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Wednesday, December 29, 2010

National Photo Co. Snow Job February 2, 1923"City Refuse Division, District of Columbia"

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Ilargi: No, really, I was too so going to write a 2011 predictions list, but then I saw one written, in the TAE comments section, by my main man and correspondent in Kenya, Africa, who calls himself VK. So I decided to be lazy and smart at the same time. I’ll sit back and take credit a year from now for all that's come true, while I’ll refer y'all to Nairobi for any and all complaints about misses. No that's not fair: I guess I’ll take VK's list and write my own little comments to go along with it, so you can blame me too. By the way, all VK wants for 2011 is a six-pack.

Allow me to start, though, with a small list of trends that are shaping up to be major issues in 2011.

First, China. And I'm not thinking so much about the new long-range anti-ship ballistic missile the Chinese appear to have developed, against which the US navy doesn't seem to have an answer, or the decision to put yet another limiting quota on rare earth minerals exports. These could be stories going forward, but it's the Chinese economy that interests me more for now.

Chinese housing prices are on track to dip early next year, with tighter monetary policy and rising inventories combining to take some air out of a market that some fear could yet swell into a bubble. The government launched a campaign late last year to brake soaring property inflation, with the top-end sector in wealthy cities especially frothy. It succeeded for a while in stabilizing prices, but there have been signs of a pick-up in recent months.

Acutely aware of public anger over costly housing, Beijing will not stand for that. It will use higher interest rates, lending curbs and a battery of direct controls, from thwarting land speculators to levying a property tax, to deflate the real estate market. "The first half of next year will be a hard time for the property sector," said Chen Dongqi, deputy chief of the Macroeconomic Research Institute under the National Development and Reform Commission, China's powerful economic planning agency.

Property prices will fall in the first six months of 2011, though by less than 10 percent, said Liu Shiqing and Xu Shengli, analysts at Essence Securities in Beijing. "Under the impact of the macro policies, shares in developers face high risks in the next two quarters," they said in a note to clients.

Beijing city is to raise its minimum wage by 21 per cent next year, the second such rise in barely six months, amid rising inflationary pressure and growing concern over China’s widening wealth gap. [..]

Every province and municipality in China has announced a rise in its minimum wage this year, with increases ranging from 12 per cent to Beijing’s 41 per cent. The official measure of annual consumer price inflation in China hit 5.1 per cent in November, up from 4.4 per cent in October, with food prices jumping 11.7 per cent in November from a year earlier.

The government is worried about the disproportionate burden of rising food costs on low-income households, which spend a larger share of their income on basic necessities. It also fears that persistent price rises could stoke social unrest, as they often have in the past.

"While China’s living standards have dramatically risen over the past 30 years, the gap between rich and poor has sharply widened," Yu Yongding, an influential former adviser to China’s central bank, wrote in an editorial last week. "With the contrast between the opulent lifestyles of the rich and the slow improvement of basic living conditions for the poor fomenting social tension, a serious backlash is brewing."

Nationwide increases in minimum wages are part of the government’s plan to reduce income disparity and the Chinese economy’s heavy reliance on investment and promote greater consumption by middle- and low-income households. But with many businesses already being squeezed by rising input costs, wage increases come at a difficult time and are likely to lead to higher overall inflation.

"In just the last three months we’ve already had to raise entry-level starting wages 60 per cent just to get people to come to a job interview," said Jade Gray, CEO of Gung Ho Pizza, a Beijing-based gourmet pizza delivery service. "With rising rents, the much higher cost of ingredients and now wage inflation, many businesses in the services industries are going to find it impossible not to pass on much higher costs to consumers."

Ilargi: Looks like China's internal troubles may be starting to take off for real. Public anger over housing and food costs makes Beijing nervous. Its response is higher interest rates and lending curbs. The risk of initiating a positive feedback loop with policies like that is exceedingly real. A feedback into more public anger, that is. Many pundits will keep claiming that China is the next major world power, economic and/or otherwise, but in essence China is a big fat bubble created by the US and EU economic bubbles, which in turn were fashioned by doomed expansionary monetary policies.

The Chinese state may not have to borrow its way into "greatness", but its people sure do. Or have, at least; all the Wen's and Wu's in charge may now try to take away the punchbowl, but their control over how events will shape up is way below where they claim it is. If and when Europe and the US begin buying less trinkets in earnest, China's domestic economy and policies will become too unpredictable for my taste.

The second issue to watch in 2011 is Japan. Just before Christmas, Tatsuo Ito and Keiko Ujikane had this for Bloomberg:

A Japanese government official who attends Bank of Japan policy board meetings said the central bank has provided adequate stimulus and it’s the "government’s turn" to try boosting demand.

"The BOJ has pretty much done everything it can do," Takashi Wada, a parliamentary secretary at the Cabinet Office and a ruling party member, said in an interview in Tokyo on Dec. 22. "It’ll probably be hard for the Bank of Japan to find more effective policy tools. So, it will be the government’s turn to make more of an effort with policy steps."

Wada’s remarks reflect reduced political pressure on the BOJ to further ease credit as the yen retreats from 15-year highs against the dollar and stocks gain. While a group of ruling Democratic Party of Japan politicians last month urged the BOJ to supply more liquidity to eradicate price declines, Wada said instead the government needs to get banks to lend more rather than invest in bonds to overcome deflation.

"The central bank has created the right environment" to encourage banks to extend more loans, said Wada, 47. "It’s strange that private banks can’t lend. They are pouring money into government bonds even though they have sufficient funds to extend loans. Their money should go into companies rather than government bonds."

Ilargi: Translation: the central bank throws the towel. Can you imagine what would happen in Europe and America if our central banks did the same? The idea now is that the government takes over. But successive Japanese governments -and there have been many- have largely been lame ducks over the entire 20-year period of deflation the country has now known. No solution should be expected to come from there.

How did Japan survive 20 years of deflation? It scraped by for the same reason China blew its bubble: American and European loose credit folly. And no matter how you view it, for instance in the light of recent quantitative easing measures and the like, the flood of western cheap money towards Japan will slow down even more than it already has. Which will put Tokyo's leaders in a precarious position. One that will make sure there will be a whole lot more successive cabinets and 'shameful' resignations. 2011 could be a decisive year for Japan.

The Chinese and Japanese conundrums may at first glance look to be 180 degrees removed from each other, but in reality they're merely two sides of the same coin.

Issue number three is US unemployment.

Bloomberg's Drake Bennett stated the obvious last week. The fact that it's stated by the main media might be significant, however:

[..] to count as unemployed one not only has to want work but to be actively searching for it. The Bureau of Labor Statistics household survey from which the rate is derived defines someone as unemployed only if he or she has searched for a job in the past four weeks: by sending out a résumé, for example, or placing an ad. This makes sense—those not even trying are unlikely to get hired. As the BLS sees it, they are not even part of the labor force. Still, that means the official stat leaves out a lot of men and women who are not working because of the particularly grinding nature of this economy.

The BLS does keep track of these nonemployed workers; it just doesn't categorize them as unemployed. Instead, it describes them as "marginally attached to the labor force." These are people who do not have a job, who would like one, and who have looked in the past year, though not the past four weeks.

Many report that they had to stop searching for personal reasons—school or illness or family responsibilities—while others say they are not looking because, in essence, they have given up. That subset is called, aptly, "discouraged workers." If the jobs number included all of these nonworkers, the November 2010 rate of 9.8 percent would climb to 11.3 percent.

Now consider those who are officially counted as employed but who are only working part-time because part-time work is all they can find. If these not-by-choice part-timers are added in, the percentage—no longer an unemployment rate, but something like a measure of the total labor underutilization of the economy—climbs to 17 percent. It's a significantly grimmer picture.

Ilargi: A grimmer picture indeed. For instance because, as Bill Black says in a recent interview at Bloomberg TV, "governments cannot remain in power with 20% unemployment". If the main media now start reporting on real US unemployment, not the BLS "official" kind, Washington could find itself in a whole lot of trouble. Given the recent history of media coverage of the financial and jobs crisis, you may be well advised not to hold your breath, but then again, it's right there, at Bloomberg. 17% US unemployment.

Unemployment, of course, feeds straight into the real estate markets. And what do you know:

Today’s release of the S&P/Case-Shiller (CSI) home price indices for October reported that the non-seasonally adjusted Composite-10 price index declined a whopping 1.24% since September, indicating that in the wake of government's housing tax gimmick, prices continue to follow sales down.

[From other source:] "On a year-over-year basis, sales are down more than 25% and the month’s supply of unsold homes is about 50% above where it was during the same months of last year."

Ilargi: There's no way you can prevent home prices from falling when you have a 17% unemployment rate. Certainly not when those same prices come off a gigantic recent bubble. It can not be done. It makes no difference how many Fannie's and Freddie's you have at your beck and call, short of the government and central bank buying all real estate and renting it out, there is no way to keep home prices inflated forever. Not that we're not trying, mind you, something your grandchildren are bound to be ever so grateful to you for.

Unemployment numbers are lies. Home prices are lies. The whole US economy -and the European one- is one big lie. We tell ourselves we're doing fine, and we persist in the illusion, even if it means making life that much harder for our own children and grandchildren. You want to claim that you love your kids? Strange way of showing it.

All of it fits into the big theme that controlled 2010: Extend and Pretend. Which the ruling parties will with all their force try to extend into 2011. But the illusion must crack at some point; hard to say how much longer people will fall for the watch-the-hand theme though. As I wrote on December 18, I do have some hope that reality may set in, since Harry Wilson at the Telegraph reported this:

Lloyds Banking Group and Royal Bank of Scotland shares tumbled on Friday after Lloyds said it had effectively written-off more than half of its outstanding loans to Irish borrowers.

In a statement, Lloyds said it had seen a "further significant deterioration in market conditions" in Ireland and that a further 10pc of its £26.7bn portfolio of Irish loans would be impaired by the end of the year.

Provisions to take account of the worsening in the portfolio will amount to an additional £4.3bn this year and total provisions now cover about 54pc of the entire loan book, effectively meaning Lloyds does not expect to get back at least half of its Irish loans. The huge write-offs have largely been driven by the collapse of the Irish property market and 90% of the bank's loans against commercial property in Ireland are impaired, meaning that the borrower is either behind on payments or unable to service the debt.

Ilargi: Obviously, Lloyds no longer pretends, or at least less than it has done to date. Funny thing is, the British government owns a 43.4% stake in Lloyds (bail-out, wouldn't you know). I'm waiting to see every single other bank that has loans outstanding in Ireland do the same Llloyds did, and certainly the ones in which Britain has a stake (that'll be all of them). It's been 11 days, and nothing so far.

Don't these other banks have shareholders (wait, what about 10 Downing Street?), and are these not interested in knowing what their shares are really worth? Does Extend and Pretend still look more promising to them even after Lloyds swallowed a 50%+ loss? Or do they just sell their shares and buy stock in a bank that doesn't write down its losses instead, no matter how obvious they are?

Nice ironies to contemplate just a few dozen hours before New Year's Day. The question for 2011 then becomes: how long can our governments and bankers extend 'Extend and Pretend'?

The answer to that question is not that easy. The financial industry has a very firm grip on government throughout the western world. It can therefore save its own -thoroughly bankrupt- skin at the expense of the public at large for a long time, at least as long as the public doesn't understand what goes on.

And since the public craves the green shoots and recovery illusion so much, it may take a while to wake it up. Then again, with real and actual unemployment numbers approaching 20% in the US, we need to remember what Bill Black says: "governments cannot remain in power with 20% unemployment". Still, Wall Street owns both sides of the aisle in Washington, so a new government makes little difference. Just feed them another puppet who can rake 'em in with yet another 'change they can believe in'.

There is a (side) effect of the Extend and Pretend, mark-to-whatever, policies, that doesn't get a lot of attention, but that may well decide the timing of the return of mark-to-market. That is, it's not just the banks that can keep roaming the plains in their zombie guises, while hiding the lost wagers that would do them in under lock in dark closets. Everybody appears much richer than they truly are, including pension funds, market funds, governments, and individuals. Yeah, you! Many parties among these, which are today still active as "investors", would no longer be that if mark-to-market would be the rule of the land.

There is therefore a huge amount of fake -or virtual- money and credit out there that is looking for profits. And it's inevitable that much of it will eventually move into commodities, thereby raising the price of oil and food and many other basic needs across the globe, including our parts of the world.

This is the ultimate perversity of our present Extend and Pretend political and financial systems. Well, that and Fannie and Freddie and their international equivalents. The desire to look richer today than you really are will make you -a lot- poorer down the line. Not just because it takes trillions of dollars per year in public funds -(future) tax revenue- in the US alone to keep the illusion alive, but also because it raises prices for everyday necessities. While at the same time, on top of all else, governments at all levels will raise taxes across the board like you wouldn't have dreamt possible until very recently.

The desire to hold on to what we want to think is normal, to what we feel we deserve, will lead to a situation where we have to pay rapidly increasing amounts of "ransom" (with interest) to keep that "normal" within our grasp. Only to find that we can't.

It'll be at that moment, when people recognize that no matter what they pay, "normal" keeps on sliding away, beyond their grip, that they will demand change. It will be too late, though, by a mile and a half; our cumulative debts can simply not be paid off anymore. After all, the gambling debts of the financial sector have long been transferred to the public sector as well.

We have borrowed our way into a fake recovery from a crisis caused by too much borrowing. You may feel great paying with plastic through the holiday season, but that too is just borrowed money - and time. And most if not all of your wealth is just an illusion, just like that so-called recovery. There was of course never a recovery; you can't borrow your way into a real recovery, only into a fake one.

Will 2011 bring us "Extend and Pretend Discovery?" I'm not 100% sure. What I am sure of is that home prices will fall, as will the stock markets, while unemployment will rise. These things are cast in stone across the western world, except perhaps for a few isolated small pockets. And at some point something's got to give. But as long as you keep craving the illusion as much as you have, and still do, it may be possible to keep this theater going for a while. After all, it will allow for even more of what you still possess to be taken away from you, since you still won't be paying attention to what really goes on.

On to the predictions.

First mine, as requested by Sharon Astyk for ASPO-USA:

Ilargi: I'm on record naming 2009 The Year of The Gullible Victim.

I named 2010 The Year of The Wake-Up Call.

And I'll now venture to name 2011 The Year of the Stone that Grinds the Family Jewels.

Well, either that, or, as my writing partner Stoneleigh phrases it: The Year of The Margin Call.

We can extend and pretend only so long. We can hand over only so many years of the people's future earnings to the banks. That is, before someone becomes suspicious of what we do. The realization that there is simply no way we can pay down our debts, whether we're in Ireland, California or Japan, will dawn in 2011, no matter what stories are spun in capital cities and TV studios.

It's high time to get out of the way of the wave that's-a-gonna-be-a-comin', and no, timing the market is NOT the main concern, even as finance types would have you believe it is. It's getting out of the way of the wave that should be your main concern.

And then VK's predictions, with my comments:

So 2011 is nearly upon us! Rejoice, rejoice as we enter our Dystopian paradise. The 11 themes of 2011 are as follows:

1) Markets begin their downturn with a vengeance. As has been stated, bullishness is at extreme levels.

Check.

2) Massive declines in real estate prices globally. The Australian and Canadian bubbles are ripe for the picking.

Check. Throw in a handful European countries for good measure. Caveat: housing markets have tons of inertia. Real bottoms may take years to reach.

3) QE2 or QE3 precipitates further deflation due to collapsing margins.

Check.

4) Commodities will plummet as demand is eviscerated. Oil below $10.

This one also could take longer than VK thinks. A lot of fake capital can flow into oil yet. Nothing to do with peak oil, however, as many will claim. Just finance, dough, credit. In the end, it's all down all the way.

5) One or more countries will leave the EuroZone, precipitating a huge confidence crisis in the single currency. Euro will collapse against the dollar.

Euro will lose vs USD, no doubt there. Countries leaving may take a few years.

6) Long term US treasuries will sell off as people realize what a basket case the revenue expense differential is. 10 Year at 4.75%.

Again, the fake money present throughout may delay this one. Interest rates sure to rise, though. As is the move towards shorter-term bonds.

7) Sharp rise in the value of the dollar. The 2008 highs on the dollar index will be easily breached.

Check?!

8) Expect more banker bailouts as the system will reach the abyss once again. Expect a few major global banks to go under.

Check on part 1. Part 2 may be harder with the bankers' check on the political system.

9) Sharp rise in global unemployment post the recent lull.

Check.

10) Social unrest due to the above, and as austerity measures will have to deepen to allow for plunging revenues.

BIG ONE. Will make Greece this summer look like a tea party. Pun intended.

11) Shortages of goods & services to emerge as international trade declines and lots of companies go bankrupt due to insufficient cash flow [and available credit] to service their debts.

Check.

And on that happy note, The Automatic Earth wishes you a great 2011.

Or, well, relatively great, if you know what I mean. And we hope you will continue to support us, and increasingly so, as things start to become even and ever more interesting. Please remember, there's danger and risk in every nook and cranny from here on in. Try to steer clear of it as much as you can. We will continue to tell you how best to do that, the way we see it.

I’ve been thinking about accounting. Actually I’ve been thinking about 2007/ 2008/ 2009/ 2010/ and 2011, the practice of accounting, the economy, business, government, and realities. Accounting is more than the collection of numbers on a few sheets of paper. Accounting has a long history of "telling what is what" at any point in time. It is supposed to be consistent, verifiable, and immune from manipulation. Au contraire, mon ami, au contraire… you might TH*NK… How does that old saying go? "Figures don’t lie, but the liars sure can figure." Please read on…

You see when I was in graduate school in business at the University of Illinois working on a Master’s Degree in "Accounting Science" in the late 1970s, the U of I had the top accounting school in the entire US. I took the required colloquium in accounting "theory" with the brilliant Professor Park. We never knew what path (or subject) he was going to attack in any one of his class sessions.

The criminal cases we covered and "discussed" seemed so disjointed and the perpetrators usually walked away initially with MILLIONS (remember that this over thirty years ago when a million was a big deal). If they were convicted at all, it usually had nothing really to do with the faulty accounting… well not really as the game played out. It was the "activity" adjuncts that nailed their sorry butts to the wall in the years later. Still… the accounting was critical to the frauds, the crimes, and the misdemeanors. And does surface prominently when the redress is sought, and the guilty parties are finally convicted.

Professor Park’s final exam for the class, which NONE of his students truly understood, was basically three questions: "Is accounting an art? A science? And, Why?" It was an evening exam so Park told us we could take as much time as we wanted. Most of the grad students were baffled and were mad as HELL.

During the last weeks of the class, I felt I had an idea about what "theory" Park was working towards in his advanced accounting theory colloquium. I started out defining "art" as a man made creation, a thing of beauty, an often misunderstood abomination, something whose value was different for each person. Yes, accounting might be construed as an "art." But, there was far more…

Accounting was also a "science" in the sense that there are rules and natural consistencies which are cumulative — that build upon each other. These can be stated and must be observed if the financial statements are to work for one and all of the users. There is a balance sheet with assets and liabilities, and an income statement which must work in unison to tell the complete story of any entity over time. There are debits and credits which must be equal in value.

A reading of the financials should be similar in interpretation to each of multiple readers, or something is amiss. Accounting is really a language — it is the language of business. The purpose of a language is to communicate. Its unfolding should divulge the same information to each of the different people who read and study its tale of what occurred in the time frame described. TH*NK about THAT in light of the events of the past years.

We have dug ourselves into a deep hole of debt. Our concepts of assets and liabilities have completely lost their way. Our money is backed only by a liability, and as such is no asset — although there is still the across the board attempt to value all things in terms of money! Does that mean that all things are liabilities?

He who owes the most wins? That has become the mantra of Wall Street and the investment lending community. Would the investment bankers have been so successful in riding this nation (and the world) into the ground were it not for this mishandling of the accounting behind the story? Would they have been able to market their derivative investments so successfully where opposites rule our TH*NK*NG and compromise our evaluative powers?

Trust me… there is no new math, no easy new path to riches, and NO new accounting which is not in reality criminal in intent. There are clearly some debits or credits missing in the financial statements we have been given to hype the most recent boom, bubble(s), fraud(s), and governmental policies. Things are about to change, they have too… The time honored truths which came from centuries of valid accounting information are going to resurface in this coming year, or year(s). This happens after every bust in history.

We are only just beginning to be shared the accounting (black) magic of the Federal Reserve Bank. The bailout was not the TARP of $800 BILLION used to purchase and warehouse the bad (as in worthless) paper assets of the financial community. It will prove to be far more than the MULTIPLE TRILLIONS in electronic money actually showered world-wide by the FED. Off the books may have been the way of the past, but it will NOT be the fix of the future!

The government and the legislative/regulatory arms of the government have been the pimps for this new "black is white" snow job of the "opposites." Governmental (or regulatory) accounting has become a terminal practice of misrepresentation. Governments operate from an income statement only presentation of their situations.

There is no balance sheet with the comprehensive statements of the assets and liabilities. They are at best package a statement of changes in liabilities as "their balance sheet." It doesn’t work, but why should it have to — it is for the government??? The checks and balances are simply not there.

Our only hope for a revelation of the whole accounting behind the story on page one of what has happened can lead us to a remedy, a fix, and a return to real prosperity. Watch the news and how accounting will prove at the center of all of it.

We will be in for quite a year… CHEERS!!!

I’m Fred Cederholm and I’ve been thinking. You should be thinking, too.

The year 2011 will bring Americans a larger and more intrusive police state, more unemployment and home foreclosures, no economic recovery, more disregard by the US government of US law, international law, the Constitution, and truth, more suspicion and distrust from allies, more hostility from the rest of the world, and new heights of media sycophancy.

2011 is shaping up as a brutal year for American democracy. The Republican Party has degenerated into a party of Brownshirts, and voter frustrations with the worsening economic crisis and military occupations gone awry are likely to bring Republicans to power in 2012. With them would come their doctrines of executive primacy over Congress, the judiciary, law, and the Constitution and America’s rightful hegemony over the world.

If not already obvious, 2010 has made clear that the US government does not care a whit for the opinions of citizens. The TSA is unequivocal that it will reach no accommodation with Americans other than the violations of their persons that it imposes by its unaccountable power. As for public opposition to war, the Associated Press reported on December 16 that "Defense Secretary Robert Gates says the U.S. can’t let public opinion sway its commitment to Afghanistan." Gates stated bluntly what has been known for some time: the idea is passe that government in a democracy serves the will of the people.

If this quaint notion is still found in civics books, it will soon be edited out. In Gag Rule, a masterful account of the suppression of dissent and the stifling of democracy, Lewis H. Lapham writes that candor is a necessary virtue if democracies are to survive their follies and crimes. But where in America today can candor be found? Certainly not in the councils of government. Attorney General John Ashcroft complained of candor-mongers to the Senate Judiciary Committee. Americans who insist on speaking their minds, Ashcroft declared, "scare people with phantoms of lost liberty," "aid terrorists," diminish our resolve," and "give ammunition to America’s enemies."

As the Department of Justice (sic) sees it, when the ACLU defends habeas corpus it is defending the ability of terrorists to blow up Americans, and when the ACLU defends the First Amendment it is defending exposures of the lies and deceptions that are the necessary scaffolding for the government’s pretense that it is doing God’s will while Satan speaks through the voices of dissent.

Neither is candor a trait in which the American media finds comfort. The neoconservative press functions as propaganda ministry for hegemonic American empire, and the "liberal" New York Times serves the same master. It was the New York Times that gave credence to the Bush regime’s lies about Iraqi weapons of mass destruction, and it was the New York Times that guaranteed Bush’s re-election by spiking the story that Bush was committing felonies by spying on Americans without obtaining warrants. Conservatives rant about the "liberal media" as if it were a vast subversive force, but they owe their beloved wars and coverups of the Bush regimes’ crimes to the New York Times.

With truth the declared enemy of the fantasy world in which the government, media, and public reside, the nation has turned on whistleblowers. Bradley Manning, who allegedly provided the media with the video made by US troops of their wanton, fun-filled slaughter of newsmen and civilians, has been abused in solitary confinement for six months.

Murdering civilians is a war crime, and as General Peter Pace, Chairman of the Joint Chiefs of Staff, said at the National Press Club on February 17, 2006, "It is the absolute responsibility of everybody in uniform to disobey an order that is either illegal or immoral" and to make such orders known. If Manning is the source of the leak, he has been wrongfully imprisoned for meeting his military responsibility. The media have yet to make the point that the person who reported the crime, not the persons who committed it, is the one who has been imprisoned, and without a trial.

The lawlessness of the US government, which has been creeping up on us for decades, broke into a full gallop in the years of the Bush/Cheney/Obama regimes. Today the government operates above the law, yet maintains that it is a democracy bringing the same to Muslims by force of arms, only briefly being sidetracked by sponsoring a military coup against democracy in Honduras and attempting to overthrow the democratic government in Venezuela. As 2011 dawns, public discourse in America has the country primed for a fascist dictatorship.

The situation will be worse by 2012. The most uncomfortable truth that emerges from the WikiLeaks saga is that American public discourse consists of cries for revenge against those who tell us truths. The vicious mendacity of the US government knows no restraint. Whether or not international law can save Julian Assange from the clutches of the Americans or death by a government black ops unit, both executive and legislative branches are working assiduously to establish the National Security State as the highest value and truth as its greatest enemy.

The two greatest visions of a future dystopia were George Orwell’s "1984" and Aldous Huxley’s "Brave New World." The debate, between those who watched our descent towards corporate totalitarianism, was who was right. Would we be, as Orwell wrote, dominated by a repressive surveillance and security state that used crude and violent forms of control? Or would we be, as Huxley envisioned, entranced by entertainment and spectacle, captivated by technology and seduced by profligate consumption to embrace our own oppression? It turns out Orwell and Huxley were both right. Huxley saw the first stage of our enslavement. Orwell saw the second.

We have been gradually disempowered by a corporate state that, as Huxley foresaw, seduced and manipulated us through sensual gratification, cheap mass-produced goods, boundless credit, political theater and amusement. While we were entertained, the regulations that once kept predatory corporate power in check were dismantled, the laws that once protected us were rewritten and we were impoverished.

Now that credit is drying up, good jobs for the working class are gone forever and mass-produced goods are unaffordable, we find ourselves transported from "Brave New World" to "1984." The state, crippled by massive deficits, endless war and corporate malfeasance, is sliding toward bankruptcy. It is time for Big Brother to take over from Huxley’s feelies, the orgy-porgy and the centrifugal bumble-puppy. We are moving from a society where we are skillfully manipulated by lies and illusions to one where we are overtly controlled.

Orwell warned of a world where books were banned. Huxley warned of a world where no one wanted to read books. Orwell warned of a state of permanent war and fear. Huxley warned of a culture diverted by mindless pleasure. Orwell warned of a state where every conversation and thought was monitored and dissent was brutally punished. Huxley warned of a state where a population, preoccupied by trivia and gossip, no longer cared about truth or information.

Orwell saw us frightened into submission. Huxley saw us seduced into submission. But Huxley, we are discovering, was merely the prelude to Orwell. Huxley understood the process by which we would be complicit in our own enslavement. Orwell understood the enslavement. Now that the corporate coup is over, we stand naked and defenseless. We are beginning to understand, as Karl Marx knew, that unfettered and unregulated capitalism is a brutal and revolutionary force that exploits human beings and the natural world until exhaustion or collapse.

"The Party seeks power entirely for its own sake," Orwell wrote in "1984." "We are not interested in the good of others; we are interested solely in power. Not wealth or luxury or long life or happiness: only power, pure power. What pure power means you will understand presently. We are different from all the oligarchies of the past, in that we know what we are doing. All the others, even those who resembled ourselves, were cowards and hypocrites. The German Nazis and the Russian Communists came very close to us in their methods, but they never had the courage to recognize their own motives.

They pretended, perhaps they even believed, that they had seized power unwillingly and for a limited time, and that just round the corner there lay a paradise where human beings would be free and equal. We are not like that. We know that no one ever seizes power with the intention of relinquishing it. Power is not a means; it is an end. One does not establish a dictatorship in order to safeguard a revolution; one makes the revolution in order to establish the dictatorship. The object of persecution is persecution. The object of torture is torture. The object of power is power."

The political philosopher Sheldon Wolin uses the term "inverted totalitarianism" in his book "Democracy Incorporated" to describe our political system. It is a term that would make sense to Huxley. In inverted totalitarianism, the sophisticated technologies of corporate control, intimidation and mass manipulation, which far surpass those employed by previous totalitarian states, are effectively masked by the glitter, noise and abundance of a consumer society. Political participation and civil liberties are gradually surrendered. The corporation state, hiding behind the smokescreen of the public relations industry, the entertainment industry and the tawdry materialism of a consumer society, devours us from the inside out. It owes no allegiance to us or the nation. It feasts upon our carcass.

The corporate state does not find its expression in a demagogue or charismatic leader. It is defined by the anonymity and facelessness of the corporation. Corporations, who hire attractive spokespeople like Barack Obama, control the uses of science, technology, education and mass communication. They control the messages in movies and television. And, as in "Brave New World," they use these tools of communication to bolster tyranny. Our systems of mass communication, as Wolin writes, "block out, eliminate whatever might introduce qualification, ambiguity, or dialogue, anything that might weaken or complicate the holistic force of their creation, to its total impression."

The result is a monochromatic system of information. Celebrity courtiers, masquerading as journalists, experts and specialists, identify our problems and patiently explain the parameters. All those who argue outside the imposed parameters are dismissed as irrelevant cranks, extremists or members of a radical left. Prescient social critics, from Ralph Nader to Noam Chomsky, are banished. Acceptable opinions have a range of A to B. The culture, under the tutelage of these corporate courtiers, becomes, as Huxley noted, a world of cheerful conformity, as well as an endless and finally fatal optimism.

We busy ourselves buying products that promise to change our lives, make us more beautiful, confident or successful as we are steadily stripped of rights, money and influence. All messages we receive through these systems of communication, whether on the nightly news or talk shows like "Oprah," promise a brighter, happier tomorrow. And this, as Wolin points out, is "the same ideology that invites corporate executives to exaggerate profits and conceal losses, but always with a sunny face."

We have been entranced, as Wolin writes, by "continuous technological advances" that "encourage elaborate fantasies of individual prowess, eternal youthfulness, beauty through surgery, actions measured in nanoseconds: a dream-laden culture of ever-expanding control and possibility, whose denizens are prone to fantasies because the vast majority have imagination but little scientific knowledge."

Our manufacturing base has been dismantled. Speculators and swindlers have looted the U.S. Treasury and stolen billions from small shareholders who had set aside money for retirement or college. Civil liberties, including habeas corpus and protection from warrantless wiretapping, have been taken away. Basic services, including public education and health care, have been handed over to the corporations to exploit for profit. The few who raise voices of dissent, who refuse to engage in the corporate happy talk, are derided by the corporate establishment as freaks.

Attitudes and temperament have been cleverly engineered by the corporate state, as with Huxley’s pliant characters in "Brave New World." The book’s protagonist, Bernard Marx, turns in frustration to his girlfriend Lenina:

"Don’t you wish you were free, Lenina?" he asks."I don’t know that you mean. I am free, free to have the most wonderful time. Everybody’s happy nowadays."He laughed, "Yes, 'Everybody’s happy nowadays.’ We have been giving the children that at five. But wouldn’t you like to be free to be happy in some other way, Lenina? In your own way, for example; not in everybody else’s way.""I don’t know what you mean," she repeated.

The façade is crumbling. And as more and more people realize that they have been used and robbed, we will move swiftly from Huxley’s "Brave New World" to Orwell’s "1984." The public, at some point, will have to face some very unpleasant truths. The good-paying jobs are not coming back. The largest deficits in human history mean that we are trapped in a debt peonage system that will be used by the corporate state to eradicate the last vestiges of social protection for citizens, including Social Security.

The state has devolved from a capitalist democracy to neo-feudalism. And when these truths become apparent, anger will replace the corporate-imposed cheerful conformity. The bleakness of our post-industrial pockets, where some 40 million Americans live in a state of poverty and tens of millions in a category called "near poverty," coupled with the lack of credit to save families from foreclosures, bank repossessions and bankruptcy from medical bills, means that inverted totalitarianism will no longer work.

We increasingly live in Orwell’s Oceania, not Huxley’s The World State. Osama bin Laden plays the role assumed by Emmanuel Goldstein in "1984." Goldstein, in the novel, is the public face of terror. His evil machinations and clandestine acts of violence dominate the nightly news. Goldstein’s image appears each day on Oceania’s television screens as part of the nation’s "Two Minutes of Hate" daily ritual. And without the intervention of the state, Goldstein, like bin Laden, will kill you. All excesses are justified in the titanic fight against evil personified.

The psychological torture of Pvt. Bradley Manning—who has now been imprisoned for seven months without being convicted of any crime—mirrors the breaking of the dissident Winston Smith at the end of "1984." Manning is being held as a "maximum custody detainee" in the brig at Marine Corps Base Quantico, in Virginia. He spends 23 of every 24 hours alone. He is denied exercise. He cannot have a pillow or sheets for his bed. Army doctors have been plying him with antidepressants. The cruder forms of torture of the Gestapo have been replaced with refined Orwellian techniques, largely developed by government psychologists, to turn dissidents like Manning into vegetables.

We break souls as well as bodies. It is more effective. Now we can all be taken to Orwell’s dreaded Room 101 to become compliant and harmless. These "special administrative measures" are regularly imposed on our dissidents, including Syed Fahad Hashmi, who was imprisoned under similar conditions for three years before going to trial. The techniques have psychologically maimed thousands of detainees in our black sites around the globe. They are the staple form of control in our maximum security prisons where the corporate state makes war on our most politically astute underclass—African-Americans. It all presages the shift from Huxley to Orwell.

"Never again will you be capable of ordinary human feeling," Winston Smith’s torturer tells him in "1984." "Everything will be dead inside you. Never again will you be capable of love, or friendship, or joy of living, or laughter, or curiosity, or courage, or integrity. You will be hollow. We shall squeeze you empty and then we shall fill you with ourselves." The noose is tightening. The era of amusement is being replaced by the era of repression.

Tens of millions of citizens have had their e-mails and phone records turned over to the government. We are the most monitored and spied-on citizenry in human history. Many of us have our daily routine caught on dozens of security cameras. Our proclivities and habits are recorded on the Internet. Our profiles are electronically generated. Our bodies are patted down at airports and filmed by scanners. And public service announcements, car inspection stickers, and public transportation posters constantly urge us to report suspicious activity. The enemy is everywhere.

Those who do not comply with the dictates of the war on terror, a war which, as Orwell noted, is endless, are brutally silenced. The draconian security measures used to cripple protests at the G-20 gatherings in Pittsburgh and Toronto were wildly disproportionate for the level of street activity. But they sent a clear message—DO NOT TRY THIS. The FBI’s targeting of antiwar and Palestinian activists, which in late September saw agents raid homes in Minneapolis and Chicago, is a harbinger of what is to come for all who dare defy the state’s official Newspeak.

The agents—our Thought Police—seized phones, computers, documents and other personal belongings. Subpoenas to appear before a grand jury have since been served on 26 people. The subpoenas cite federal law prohibiting "providing material support or resources to designated foreign terrorist organizations." Terror, even for those who have nothing to do with terror, becomes the blunt instrument used by Big Brother to protect us from ourselves.

"Do you begin to see, then, what kind of world we are creating?" Orwell wrote. "It is the exact opposite of the stupid hedonistic Utopias that the old reformers imagined. A world of fear and treachery and torment, a world of trampling and being trampled upon, a world which will grow not less but more merciless as it refines itself."

The role of the criminal justice system with regard to financial fraud by elite bankers in 2011 is likely to reprise its role last decade — de facto decriminalization. The Galleon investigation of insider trading at hedge funds will take much of the FBI’s and the Department of Justice’s (DOJ) focus.

The state attorneys general investigations of foreclosure fraud do focus on the major players such as the Bank of America (BoA), but they are unlikely to lead to criminal liability for any senior bank officials. It is most likely that they will lead to financial settlements that include new funding for loan modifications.

The FBI and the DOJ remain unlikely to prosecute the elite bank officers that ran the enormous “accounting control frauds” that drove the financial crisis. While over 1000 elites were convicted of felonies arising from the savings and loan (S&L) debacle, there are no convictions of controlling officers of the large nonprime lenders. The only indictment of controlling officers of a far smaller nonprime lender arose not from an investigation of the nonprime loans but rather from the lender’s alleged efforts to defraud the federal government’s TARP bailout program.

What has gone so catastrophically wrong with DOJ, and why has it continued so long? The fundamental flaw is that DOJ’s senior leadership cannot conceive of elite bankers as criminals. On Huffington Post, David Heath writes:

Benjamin Wagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases in Sacramento, Calif., points out that banks lose money when a loan turns out to be fraudulent. An investor in loans who documents fraud can force a bank to buy the loan back. But convincing a jury that executives intended to make fraudulent loans, and thus should be held criminally responsible, may be too difficult of a hurdle for prosecutors. ‘It doesn’t make any sense to me that they would be deliberately defrauding themselves,’ Wagner said.”

Mr. Wagner is confused by his own pronouns: “It doesn’t make any sense to me that they would be deliberately defrauding themselves.” This direct quotation needs to be read in conjunction with the author’s description of his position: “banks lose money” when loans “turn out to be fraudulent.” Wagner was responding to a question about control fraud — frauds led by the person controlling the seemingly legitimate entity who uses it as a “weapon.” The relevant “they” is the person looting the bank — the CEO. The word “themselves” refers not to the CEO, but rather to the bank. The CEO is not looting the CEO; he is looting the bank’s creditors and shareholders. Two titles capture this well known fraud dynamic. The Nobel laureate in economics, George Akerlof, and Paul Romer co-authored Looting: the Economic Underworld of Bankruptcy for Profit in 1993 and I wrote The Best Way to Rob a Bank is to Own One (2005). The CEO becomes wealthy by looting the bank. He uses accounting as his ammunition because, to quote Akerlof & Romer, it is “a sure thing.” The firm fails (or in the modern era, is bailed out), but the CEO walks away wealthy.

Here is the four-part recipe for maximizing fraudulent accounting income in the short-term:

1. Grow extremely rapidly

2. By making bad loans at high yields

3. While employing extreme leverage, and

4. Providing only minimal loss reserves

A bank that follows this recipe is mathematically guaranteed to report record income in the near term. The first two ingredients in the recipe are linked. A bank in a reasonably competitive, mature market such as home mortgage lending cannot decide to grow extremely rapidly by making good loans. A bank can, however, guarantee its ability to grow rapidly — and charge a premium yield — if it lends to the tens of millions of people who cannot afford to own a home. Equally importantly, if many lenders follow the same recipe they will cause a financial bubble to hyper-inflate. Financial bubbles extend the lives of accounting control frauds by making it simple to refinance loans to those who cannot afford to purchase the asset. The longer that delinquencies and defaults can be delayed the more the CEO can loot the bank.

Note that the same recipe that maximizes short-term fictional income in the near term maximizes real losses in the longer term. Mr. Wagner is unable to understand that accounting control fraud represents the ultimate “agency” problem — the unfaithful agent (the CEO) enriches himself at the expense of the principals he is supposed to serve and the firm’s creditors. Agency problems are well known to white-collar criminologists, economists, lawyers that practice corporate, securities, or criminal law, and financial regulators. Yes, accounting control fraud causes the bank to suffer huge losses. The loans don’t “turn out to be fraudulent” — they are fraudulent when made. The recognition of the losses is delayed when an epidemic of accounting control fraud hyper-inflates a bubble, but the bubble will increase the ultimate losses. Sacramento, California is one of the epicenters of the mortgage fraud that drove the financial crisis, so Mr. Wagner’s lack of understanding of fraud mechanisms is particularly harmful.

Financial regulators are essential to prevent this kind of error by senior prosecutors. The regulators have to serve as the Sherpas for the criminal justice system to succeed against epidemics of control fraud. The FBI cannot have hundreds of agents expert in many hundreds of industries. The regulators have to do the heavy investigative lifting. They have the expertise and greater staff resources. The regulators also have to serve as the guides. Their criminal referrals have to provide the roadmaps that allow the FBI to conduct successful investigations. The regulators played this role successfully at key times during the S&L debacle, filing thousands of criminal referrals that led to over 1000 priority felony convictions. During the current crisis the OCC and the OTS - combined - made zero criminal referrals. None of the federal regulatory agencies appear to have enforced the regulatory mandate that federally insured depositories file criminal referrals - and noncompliance with that requirement was and is the norm. There is no indication that the FBI has demanded that the regulators enforce their rules.

Absent guidance and support from the regulators, the FBI turned to the worst conceivable source of guidance and support - the trade association of the “perps” — the Mortgage Bankers Association (MBA). The MBA, predictably, defined its members as the victims of mortgage fraud. The MBA invented a nonsensical definition of mortgage fraud which made accounting control fraud impossible. All fraud supposedly fell into one of two categories: “fraud for housing” or “fraud for profit.” The MBA members are, in fact, victims of accounting control fraud. The mortgage banks, however, do not set MBA policy. The CEOs of the mortgage banks determine MBA policy and they are not about to tell the FBI that they are the primary source of the epidemic of mortgage fraud. Similarly, they are not about to make criminal referrals, which might cause the FBI to investigate why some lenders made loans that were overwhelmingly fraudulent. MBA members virtually never made criminal referrals even though they made millions of fraudulent loans. Why don’t the victims make criminal referrals and help the FBI protect them from the frauds?

Why did an industry, home mortgage lending, which had traditionally been able to keep losses from all sources to roughly one percent suddenly begin to suffer 80-100 percent fraud incidence on “liar’s” loans? Why would an honest mortgage lender make “liar’s” loans knowing that doing so would produce intense “adverse selection” and a “negative expected value”? They would not do so. They were not mandated to do so by federal regulation or law. They were not encouraged to do so by federal regulation or law. They did so because their CEOs decided they would do so in order to maximize fictional income and real bonuses. The CEOs increased the number of liar’s loans they made after they were warned by the FBI that there was an “epidemic” of mortgage fraud and the FBI predicted it would cause an “economic crisis” were it not contained. The CEOs increased their liar’s loans after the MBA’s own anti-fraud experts stated that they deserved the name “liar’s” loans because they were pervasively fraudulent and after those experts said that “liar’s” loans were “an open invitation to fraudsters.” The industry’s formal euphemisms for liar’s loans were “alt-a” and “stated income” loans. None of this makes sense for honest CEOs.

The federal regulators have not made any public study of liar’s loans. The FDIC and OTS’ joint data system on mortgages is an anti-study — it uses a categorization system that ignores whether the loans were underwritten. This makes the data base useless for studying loans made without full underwriting — the loans that were overwhelmingly fraudulent and drove the crisis. Credit Suisse reported that mortgage loans without full underwriting constituted 49% of all new originations in 2006. If that percentage is even in the ballpark it indicates that that there were millions of fraudulent loans originated in 2005-2007. It is appalling that the regulators are not studying the facts necessary to understand the crisis and hold the perpetrator accountable.

Fortunately, the state attorneys general have studied these mechanisms and they have found that it was the lenders and their agents that overwhelmingly (1) prompted the false loan application data and (2) coerced appraisers to inflate market values. An honest lender would never engage in either practice or permit its agents to do so. The federal regulators, however, have spent their passion trying to preempt state efforts to protect borrowers. The federal regulators took no effective action in response to the State AGs’ findings.

The combined effect of these private sector, regulatory, and criminal justice failures has created a set of intellectual blinders that have caused DOJ to mischaracterize the nature of mortgage fraud. Attorney General Mukasey famously dismissed the epidemic of mortgage fraud as “white-collar street crime.” He did so in the context of refusing to establish a national task force against mortgage fraud. A national task force is essential in this crisis because of the national lending scope of many of the worst accounting control frauds. Attorney General Holder has maintained Mukasey’s passive approach to the elite frauds that drove the crisis.

The U.S. needs to take three major steps to be effective against the epidemic of accounting control fraud. First, DOJ needs to realize that it is dealing with accounting control fraud. That task is not terribly difficult. The criminology, economics, and regulatory literature — as well as the data on fraud and analytics are all readily available. The FBI must end its “partnership” with the MBA.

Second, the regulators need new leadership picked for a track record of success as vigorous regulators and a willingness to hold elites accountable regardless of their political allies. The regulators need to make assisting prosecutions, and bringing civil and enforcement actions, against the senior officers that led the control frauds their top priority. The regulators need to make detailed criminal referrals, enforce vigorously the regulatory mandate that insured depositories file criminal referrals, and prioritize banks that made large numbers of nonprime loans but few criminal referrals. The regulators need to work with DOJ to prioritize the cases. In the S&L debacle we used a formal process to create our “Top 100″ priority cases. The regulators need to investigate rigorously every large nonprime lending specialist by creating a comprehensive national data base. We have unique opportunities given the massive holding of nonprime paper by the Fed and Fannie and Freddie to create a reliable data base and use it to conduct reliable studies and investigations.

Third, the regulators and the DOJ need to partner with the SEC and the state AGs to share data (where appropriate under Grand Jury rule 6e). The federal regulators need to end their unholy war against state regulatory efforts and the SEC needs to end its disdain for the state AGs. The SEC needs to clean up accounting and the Big Four audit firms. The bank control frauds’ “weapon of choice” is accounting. The Big Four audit firms consistently gave clean opinions to even the most egregious frauds. Provisions for losses (ALLL) fell to farcical levels. Losses were not recognized. Clear evidence of endemic fraud was ignored.

What are the prospects for these three vital changes occurring in 2011? They are poor. There is no evidence that any of the three changes is in process. The new House committee chairs have championed even weaker regulation and have not championed the prosecution of Wall Street elites.

The media, however, has begun to pick up our warnings about the failure of the criminal justice response to the epidemic of fraud. Prominent economists, particularly Joseph Stiglitz and Alan Greenspan, have joined Akerlof, Romer, Galbraith,Wray, and Prasch in emphasizing the key role that elite fraud played in driving this crisis. Even Andrew Ross Sorkin, generally seen as an apologist for the Street’s elites, has decried the lack of prosecutions.

Our best bet is to continue to win the scholarly disputes and to continue to push media representatives to take fraud seriously. If the media demands for prosecution of the elite banking frauds expand there is a chance to create a bipartisan coalition in Congress and the administration supporting prosecutions. In the S&L debacle, Representative Annunzio was one of the leading opponents of reregulation and leading supporters of Charles Keating. After we brought several hundred successful prosecutions he began wearing a huge button: “Jail the S&L Crooks!” Bringing many hundreds of enforcement actions, civil suits, and prosecutions causes huge changes in the way a crisis is perceived. It makes tens of thousands of documents detailing the frauds public. It generates thousands of national and local news stories discussing the nature of the frauds and how wealthy the senior officers became through the frauds. All of this increases the saliency of fraud and increases demands for serious reforms, adequate resources for the regulators and criminal justice bodies, and makes clear that elite fraud poses a severe danger. Collectively, this creates the political space for real reform, vigorous regulators, and real prosecutors.

Today’s release of the S&P/Case-Shiller (CSI) home price indices for October (browse the dashboard) reported that the non-seasonally adjusted Composite-10 price index declined a whopping 1.24% since September, indicating that in the wake of government's housing tax gimmick, prices continue to follow sales down.

It's important to recognize that as we continue to move away from the government's tax sham, the home sales and price movement fueled by that epic monstrosity are left further and further behind.

Yet, it will be some time before the effects are completely expunged from the CSI as its methodology uses a three month rolling average of the source data and further, as BostonBubble points out, since Congress moved to extend the closing deadline for the credit until September, the CSI data may not be free of the distortion until the February 2011 release!

In any event, you can see from the latest CSI data that the price trends are starting to slump and, as I recently pointed out, the more timely and less distorted Radar Logic RPX data is already capturing notable price weakness nationwide.

The 10-city composite index increased just 0.22% as compared to October 2009 while the 20-city composite increased 0.80% over the same period.

Topping the list of regional peak decliners was Las Vegas at -56.99%, Phoenix at -53.40%, Miami at -48.72%, Detroit at -45.80% and Tampa at -43.21%.

Additionally, both of the broad composite indices show significant peak declines slumping -29.72% for the 10-city national index and -29.63% for the 20-city national index on a peak comparison basis.

Housing markets have taken a turn for the worse, with the widely followed S&P/Case-Shiller index declining more than analysts had forecast in October, lending credence to the housing bears who have predicted a double dip.

The real-estate sector has been one of the sticking points in the Fed and the government’s attempts to revive the U.S. economy. The 20-city composite S&P/Case-Shiller Index, which measures the value of single homes in 20 metropolitan areas, declined 1% from September to October on a seasonally adjusted basis, S&P said Tuesday. That exceeded the 0.8% dip expected by Wall Street analysts. The index, which takes January 2000 as its base with a value of 100, hit 145.32, making October the fifth consecutive month where annual growth rates moderated from their prior month’s pace.

"The double dip is almost here," said David Blitzer, chairman of S&P’s index committee."There is no good news in October’s report." Explaining that "the trends we have seen over the past few months have not changed," Blitzer cited expired tax incentives and a "lackluster" national economy as some of the causes. "On a year-over-year basis, sales are down more than 25% and the month’s supply of unsold homes is about 50% above where it was during the same months of last year."

Atlanta and Minneapolis suffered the steepest drops, with seasonally adjusted falls of 2.1% and 1.8% respectively. Denver and Washington were the only metropolitan regions to show sequential price gains on a seasonally adjusted basis, gaining 0.3% and 0.1% respectively. Excluding seasonal corrections, all 20 areas showed declines.

Stalled foreclosures waiting to hit the market will put additional downward pressure on prices, according to Westwood Capital. "The market has still not completed the price discovery necessary to determine the final value of housing – after all, easy money policy is still producing affordability that has masked the failure of prices to completely readjust to normalized levels," Westwood said in a research note. "The most striking thing about [Tuesday’s] report is that we are seeing a repeat of the price decline patterns that appeared during the 2006-2009 downturn," Westwood said, pointing to declines starting in "sand state" markets and gradually spreading to the balance of the remaining markets.

The 20-city index is still 4.4% above its April ’09 trough, but remains 29.6% down from its July 2006 peak. Ben Bernanke and the Federal Reserve have pledged to do whatever is in their power to help the economic recovery. In the FOMC’s last meeting of the year, held on December 14, the committee pledged to continue its policy of quantitative easing by purchasing long and medium-term Treasuries, in order to keep interest rates low and stimulate risk appetite. Housing bears abound, though, such as Nouriel Roubini, who predicted a double-dip in housing early in December, claiming problems could even spread to the "prime" market.

Are local home prices back into a "double dip" tumble? We frequently track year-over-year price comparisons to watch for bigger trends, since this data can eliminate the common seasonal swings from the math.

Prices often rise during peak buying season in the spring and this year was no exception, thanks in part to some tax incentives to buyers. Yet it's obvious looking at numerous reports that prices have fallen since this year's traditional sales rush as the tax breaks faded away.

Still, on our preferred year-over-year basis, it's been hard to confirm the negative price swing. But recently we found that a price index from CoreLogic showed Orange County home values falling at a 2.56 percent year-over-year rate in October. CoreLogic is the old data-collecting unit of title-insurance giant First American.

October marked the second straight month of year-over-year declines in this local CoreLogic index following eight consecutive increases. Before that upswing, the CoreLogic index for Orange County had fallen 37 straight months on a year-over-year basis.

This CoreLogic index is a "paired sales" benchmark based on tracking gains or losses on individual homes sold recently — including distressed sales. (Another CoreLogic compilation, done with the Real Estate Research Council of Southern California, estimates the value of all homes in the county. It shows a 3.15 annual gain in the third quarter.)

Before we found this declining CoreLogic paired sales index, the only other major index we track that had shown a year-over-year decline was the California Realtors gauge. This marker — down 4.4 percent annual for October — is based on sales of old single-family homes in the brokers' MLS tracking system. Not that other indexes are showing huge year-over-year price gains to deflect the argument that prices are still rising.

For example, widely watched DataQuick's median selling price for all residences for November was up a scant 0.6 percent vs. a year ago. That came after it rose just 0.3 percent in October vs. 2009. DataQuick's math includes sales in the recently resurgent new homes market, residences that are typically pricier that the median. That trend may be keeping DataQuick's median price above the year-ago level.

Plus, when you look inside the November DataQuick stats at ZIP code level we find that when taking sales volume in consideration, pricing is up in ZIPs representing just 33 percent of the Orange County market. In addition, DataQuick's November shows the price per square foot paid for a home in November fell on a year-over-year basis by 1.9 percent. That is the first decline in this index since October 2009. It will be interesting to watch how many of the local home price indexes turn negative this winter – and if the usually more active spring selling season will change those trends.

Slump CountyNobody can debate that Orange County homebuying is sluggish, with November sales off 11 percent from a year ago. Geographically, it's a broad-based slump: Weakness was most profound to the north and inland. In Orange County's north-inland ZIP codes, 530 homes sold in the month, down 17 percent from a year ago. Mid-county ZIPs had 598 sales, down 24 percent from a year ago.

It was not terribly better to the south or near the ocean. In beach-close cities, 403 homes sold – down just 2 percent from a year ago. And in south inland ZIPs — now the county's business market – the 633 sales were down 9 percent from a year ago.

California Hurtin'That same CoreLogic paired-sales index is flashing a loss signal for California home prices, too. Statewide pricing — including distressed sales — were falling at 0.89 percent annual rate in October, by this math. That's the first year-over-year decline in CoreLogic's database for the state's values since December 2009. For October, the five states with the highest year-to-year appreciation by CoreLogic's math were: North Dakota (up 4.6 percent), West Virginia (up 3.4 percent), Vermont (up 2.6 percent), Maine (up 2 percent) and Wyoming (up 1.9 percent).

Greatest depreciation? Idaho, down 15.1 percent, followed by Alabama (off 9.3 percent); Oregon (down 8.5 percent); Arizona (down 8.25 percent) and Florida (off 8 percent). According to the CoreLogic price indexes, national home prices declined by 3.93 percent in October vs. a year ago. From a peak in April 2006 to October, national prices are off 30.2 percent.

Mark Fleming, chief economist for CoreLogic: "We are continuing to see the weakness in home prices without artificial government support in the form of tax credits. The stubborn unemployment levels and seasonality are also coming into play. When you combine these factors with high shadow and visible inventories, the prospect for a housing recovery in early 2011 is fading."

According to economist Nouriel Roubini, the housing market is in a double dip. And negative Case-Shiller Home Price numbers out today only confirm that unpleasant truth. "It's pretty clear the housing market has already double dipped," says Roubini. "And the rate of decline is stronger than in previous months," he said of the new housing data.

Aside from below trend economic growth, there are two factors specific to the housing market that are putting downward pressure on home prices. The first factor is the expiration of federal home buyer tax credits for first time home buyers. "If you look at the data, Case Shiller has been falling every month since the tax credit expired in May. Everyone who wanted to buy a home did so by April," Roubini said.

"That tax credit stole demand from the future and its expiration led to another 30% fall in home sales, pushing Case & Shiller lower for the last few months," Roubini wrote in a text message earlier this morning.

The second factor putting downward pressure on home prices is the ongoing chaos with mortgage documentation, and the consequent suspension by banks of mortgage foreclosure proceedings—which has actually worsened the underlying problems in the housing market. "There has been an effective moratorium on foreclosure," said Roubini.

And the beginning of the end of that moratorium means more housing supply is about to become available on the market. "The shadow inventory of not-yet-foreclosed homes—due to the moratorium—will surge in the next year," Roubini says. Both factors, taken in concert, set up a scenario where market fundamentals put downward pressure on prices: "Supply will increase, demand will drop," Roubini said.

The Case Shiller Composite-20 Index, which represents the broadest measure of U.S. home prices in the survey, fell 1 percent on an adjusted basis during the September/October time period, based on data release earlier today. All 20 Metropolitan Statistical Areas included in the survey showed declines—reflecting a broad based, non-regional erosion of prices in the housing sector.

But Roubini isn't yet predicting a double dip recession for the broader economy. "The rest of the economy is recovering. Most of the numbers are consistent with a growth rate of 2.7 percent," Roubini said. But that 2.7 percent growth is still below trend. "So unemployment will likely remain above 9 percent," according to Roubini's analysis.

Roubini adds that there are other ominous economic signs on the horizon including: "The eurozone shock, long-term structural deficits, and state and local governments [operating near] bankruptcy." And, if homeowners begin walking away from their properties en masse, those negative trends might well pick up steam:

"12 million households are already in negative equity and 8 million more have an LTV btw 95 and 100%. Thus even a 5% fall in home price will push an extra 8 million in negative equity with risk of millions walking away from their home—i.e. jingle mail," Roubini wrote me in a text message earlier today. It's certainly a sobering scenario to contemplate as we head into the New Year.

Consumer confidence slipped this month as more people worried that the job market is worsening. The latest survey from Conference Board showed a decline even after reports are showing that people increased their holiday spending at the biggest rate in four years and other indicators suggest the economy is brightening.

The private research group said Tuesday its Consumer Confidence Index fell to 52.5 in December, down from a revised 54.3 in November. Economists were expecting 55.8. The decline reverses two c onsecutive months of increases. It takes a reading of 90 to indicate a healthy economy, a level not approached since the recession began in 2007.

People are less confident even though layoffs are slowing, businesses are buying more goods, and consumers are spending more money. Economists have raised their growth forecasts for the final months of the year and 2011.

Still, home prices fell in the nation's largest cities and are expected to decline further next year. Every city in the Standard & Poor's/Case Shiller 20-city home price index showed a monthly price decline in October from September the first time that has happened since Feb. 2009.

And the unemployment rate increased to 9.8 percent in November from 9.6 percent in October.

"Although the economy is growing again, consumer attitudes are lagging behind broader economic developments," said Steven Wood, chief economist at Insight Economics. Woods said people are more concerned with high unemployment, falling home prices and the number of foreclosures.

Economists watch confidence closely because consumer spending accounts for about 70 percent of U.S. economic activity. One measure of the Confidence Index, which assesses how shoppers feel now about the economy, declined to 23.5 in December, from 25.4 in November. The other barometer, which measures how shoppers feel about the economy over the next six months, fell to 71.9 from 73.6 in November.

Fewer people see jobs as "plentiful", the survey noted, while more described jobs as "hard to get." "Despite this month's modest decline, consumer confidence is no worse off today than it was a year ago," said Lynn Franco, director of Consumer Research Center at The Conference Board, in a statement. "Consumers' assessment of the current state of the economy and labor market remains tepid, and their outlook remains cautious. "

Still, people spent more this holiday season than the past year, a sign that they have some faith in the economy. Retails had to work to get their money, offering free shipping and discounts as early as October. "The consumer is still very value-driven," said Scott Krugman, a spokesman at the NRF, the nation's largest retail trade group. "(The holiday season) is e ncouraging. The reality is that consumers need more proof that we are out of a recession. Hopefully, that will happen in 2011."

The National Retail Federation predicts spending this holiday season, Nov. 1 through Dec. 31, will reach $451.5 billion. That's up 3.3 percent over last year. That forecast was upgraded earlier this month based on a robust November. That would be the biggest increase since 2006, and the largest total since a record $452.8 billion in 2007. The NRF forecast excludes revenue from restaurants, gas and autos and only looks at online sales from physical stores.

The International Council of Shopping Centers said Tuesday that revenue at stores opened at least a year is so far tracking at 4.0 percent, which would make it the strongest growth rate since 2006, when the figure was 4.4 percent. The period is from Nov. 1 through Saturday. The measure is a key indicator of a retailer's health. The Consumer Confidence Index is based on a survey of 5,000 consumers with a cutoff date of Dec. 20.

The U.S. economy will probably grow no more than 2 percent in 2011, less than what’s needed to lower unemployment, Nobel-prize winning economist Robert Mundell said. "I don’t see economic growth as being any better than 2 percent," the Columbia University economics professor said in an interview today on Bloomberg Television’s "Street Smarts" with Carol Massar.

"You had this financial shock to the economy which devastated confidence, and there is nothing around the corner that looks like it’s going to be a strong push for the economy."

The economy grew at an average 2.9 percent annual rate in the five quarters since the worst recession in seven decades ended in June 2009. That pace of recovery has lowered unemployment from a peak of 10.1 percent in October 2009 to 9.8 percent last month. Mundell, 78, said the Fed’s unconventional monetary policy actions, known as quantitative easing, had the undesired effect of strengthening the dollar.

"The Fed policy was working three or four times before, but then it was cut off because the dollar soared and that’s what really broke the back of the economy," he said. The Fed has been "negligent" in not taking into account the influence a rising dollar would have on the economy, he said.

I keep hearing from the data zealots that holiday sales were impressive and the outlook for the economy in 2011 is not bad. Maybe they’ve stumbled onto something in their windowless rooms. Maybe the economy really is gathering steam. But in the rough and tumble of the real world, where families have to feed themselves and pay their bills, there are an awful lot of Americans being left behind.

A continuing national survey of workers who lost their jobs during the Great Recession, conducted by two professors at Rutgers University, offers anything but a rosy view of the economic prospects for ordinary Americans. It paints, instead, a portrait filled with gloom.

More than 15 million Americans are officially classified as jobless. The professors, at the John J. Heldrich Center for Workforce Development at Rutgers, have been following their representative sample of workers since the summer of 2009. The report on their latest survey, just out this month, is titled: "The Shattered American Dream: Unemployed Workers Lose Ground, Hope, and Faith in Their Futures."

Over the 15 months that the surveys have been conducted, just one-quarter of the workers have found full-time jobs, nearly all of them for less pay and with fewer or no benefits. "For those who remain unemployed," the report says, "the cupboard has long been bare." These were not the folks being coldly and precisely monitored, classified and quantified as they made their way to the malls to kick-start the economy. These were among the many millions of Americans who spent the holidays hurting.

As the report states: "The recession has been a cataclysm that will have an enduring effect. It is hard to overstate the dire shape of the unemployed." Nearly two-thirds of the unemployed workers who were surveyed have been out of work for a year or more. More than a third have been jobless for two years. With their savings exhausted, many have borrowed money from relatives or friends, sold possessions to make ends meet and decided against medical examinations or treatments they previously would have considered essential.

Older workers who are jobless are caught in a particularly precarious state of affairs. As the report put it: "We are witnessing the birth of a new class — the involuntarily retired. Many of those over age 50 believe they will not work again at a full-time 'real’ job commensurate with their education and training.

More than one-quarter say they expect to retire earlier than they want, which has long-term consequences for themselves and society. Many will file for Social Security as soon as they are eligible, despite the fact that they would receive greater benefits if they were able to delay retiring for a few years."

There is a fundamental disconnect between economic indicators pointing in a positive direction and the experience of millions of American families fighting desperately to fend off destitution. Some three out of every four Americans have been personally touched by the recession — either they’ve lost a job or a relative or close friend has. And the outlook, despite the spin being put on the latest data, is not promising.

No one is forecasting a substantial reduction in unemployment rates next year. And, as Motoko Rich reported in The Times this month, temporary workers accounted for 80 percent of the 50,000 jobs added by private sector employers in November.

Carl Van Horn, the director of the Heldrich Center and one of the two professors (the other is Cliff Zukin) conducting the survey, said he was struck by how pessimistic some of the respondents have become — not just about their own situation but about the nation’s future. The survey found that workers in general are increasingly accepting the notion that the effects of the recession will be permanent, that they are the result of fundamental changes in the national economy.

"They’re losing the idea that if you are determined and work hard, you can get ahead," said Dr. Van Horn. "They’re losing that sense of optimism. They don’t think that they or their children are going to fare particularly well."

The fact that so many Americans are out of work, or working at jobs that don’t pay well, undermines the prospects for a robust recovery. Jobless people don’t buy a lot of flat-screen TVs. What we’re really seeing is an erosion of standards of living for an enormous portion of the population, including a substantial segment of the once solid middle class.

Not only is this not being addressed, but the self-serving, rightward lurch in Washington is all but guaranteed to make matters worse for working people. The zealots reading the economic tea leaves see brighter days ahead. They can afford to be sanguine. They’re working.

Less than a year ago, Francis Campos-Dunn was still working at a county hospital in the San Francisco Bay Area, helping patients navigate the often-maddening bureaucracy required to draw on their health insurance. These days, she has a new set of problems to navigate: how to manage her own care without any insurance of her own, having slipped into an unfortunate but fast-growing slice of the population--Americans who have lost their jobs and now lack health coverage.

Back when she was still working, Campos-Dunn, 42, earned $4,000 a month, enough to make her co-payments for regular medical care. These days, she depends on $300 a month contributions from her 16-year-old son--money he earns at a part-time job--just to pay to the rent. When a recent seizure left her with two broken teeth, she skipped the required treatment and opted to have the teeth pulled instead, because she lacked the funds--a choice that would have previously seemed unthinkable.

As the Great Recession has sown unemployment and downgraded work even for those people who have held on to their jobs, the number of Americans lacking healthcare has swelled beyond 50 million, according to a sobering new report from the Kaiser Foundation. Among the report's most troubling findings: The number of Americans without any health care coverage grew by more than four million in 2009. That left almost one-fifth of non-elderly people uninsured. Among those between 19 and 29 years old, nearly one-third lacked coverage.

The study underscores the degree to which the recession has accelerated the loss of basic elements once viewed as inextricable pieces of a middle class life. The number of Americans lacking medical coverage now exceeds the population of Spain. Nearly all Americans over 65 are insured by Medicare, the government-run health care plan, but those beneath that age are increasingly vulnerable to losing health care once provided by their employers or finding themselves unable to afford private coverage, according to the report, "The Uninsured: A Primer."

As those lacking health insurance grow in number, so do those missing out on necessary medical attention. About one-in-four uninsured adults have forgone care in the past year because of costs, compared to only 4 percent of those who have private coverage, according to the report.

Those lacking health coverage are vulnerable to what has become a commonplace financial calamity: confronting a medical emergency, and having to pay for care entirely out of pocket. This year, 27% of uninsured adults used up most or all of their savings paying medical bills, according to the study. Half of these uninsured households had total assets of $600 or less.

Medicaid covers Americans with the lowest incomes, but that fact merely mitigates conditions for people in abysmal circumstances: Medicaid beneficiaries are typically in much worse health than those with private coverage. They are likely to have incomes that place them well below the poverty line, and to suffer health conditions that impede their ability to work, exacerbating their difficulties.

Under the health reforms championed by President Obama, Medicaid is set to expand in 2014 to cover almost all people under 65 with incomes up to 138% of the federal poverty line. That would provide health care to many more Americans who now lack coverage. But until then, many Americans will continue to shoulder the burden of unaffordable health care costs.

The soaring number of people falling through the cracks and going without health insurance is in large part the result of the recession, which has eliminated millions of jobs, along with employer-sponsored coverage. Roughly half of all working age Americans with insurance have it through their employer. Even among those who have avoided unemployment, millions have been forced to take temporary or part-time positions for lack of available full-time work, often surrendering their benefits in the process.

More than half of those who are officially unemployed have no health coverage whatsoever, according to a Rutgers University study, "The Shattered American Dream: Unemployed Workers Lose Ground, Hope, and Faith in their Future." Those numbers increase to nearly 60% for those who have been unemployed for over six months. Six in ten unemployed Americans have been unemployed for over a year.

Yet even if the economy soon adds more jobs and lowers the ranks of the unemployed, the scarcity of health coverage is likely to endure, argues one of the study's authors, Carl Van Horn, Professor of Public Policy at Rutgers University and Director of the John J. Heldrich Center for Workforce Development. Long before the recession, he noted, having a job conveyed no guarantee of coverage. "Just recovery of jobs isn't sufficent to address the issue," he said. "A lot of the jobs that people are getting are part-time jobs and/or don't have healthcare benefits attached to them."

And even those who are eligible for healthcare in the wake of job loss cannot always take advantage of what is available to them. "It's pretty obvious that government policies are confusing," Van Horn said. "A lot of folks are losing their jobs for the first time and they don't know what they're even entitled to." Paying for healthcare can be one of the first things to go for families dealing with constrained finances. Over 50% of those surveyed said that healthcare was one of the expenses they could not afford to pay. "We have an employer-based healthcare system," Van Horn said. "And if your lose your job, unless you're old or very poor, you have no health care insurance."

In San Mateo, California, just south of San Francisco, Francis Campos-Dunn understands this fact all too well. For years, she has contended with a variety of often-expensive health problems, making her insurance situation particularly crucial. Her administrative job at the San Mateo County Hospital provided for her needs and also delivered insurance for her son and a granddaughter. But late last year, she was laid off, and so began a painful and bewildering lesson in the particularities of the American health care system.

Kaiser, the giant health maintenance organization, offered her the option to continue her health insurance for $1,500 dollars a month. But that outstripped her total income-- a disability payment of $1,300 a month. So Campos-Dunn turned to Medical, California's state-run health insurance--the state's version of Medicaid. But they told her that her income exceeded the allowable limit by $32 a month and denied her claim, she says. Undeterred, she appealed, was granted a hearing and was subsequently approved for the state insurance.

But three weeks later, another letter arrived informing her that once again, she made too much money to qualify for the state's health insurance. Since her unemployment, she has struggled with this ceaseless back and forth with the bureaucracy, going without care for weeks in between. "I never thought I'd be in this position," she said. "I used to help families get on insurance. I used to hear all these problems. I used to think anything was possible to try to figure out a way around it so they could get health insurance. Now I have no health insurance."

With her medical condition continuing to require care, her battle to keep up has worn her down past the point where she can even muster the effort to continue fighting. "It got up to a point where I didn't even try to deal with them anymore," she said. "If I ended up in the hospital I'd just pay the bill." She now owes Kaiser over $55,000, she says. She owes the San Mateo County Hospital--her old employer-- over $22,000. "I just don't think it's right," she said. "I've been working since I was 15 years old and now I can't access what I need because I make 32 dollars too much."

Faced with the need to make drastic cuts to avoid looming budget holes as federal stimulus money runs out, school districts across the country are resorting to once-unthinkable solutions. Officials are turning to desperate measures to save the jobs of teachers, whose livelihoods were long considered secure.

In Boston, the superintendent has chosen to close nine schools and merge eight others into four buildings in light of a potential $63 million shortfall next year. School officials in Camp Hill, Pa., are so eager to raise funds that they've offered to sell naming rights to their gyms ($250,000 each), the library ($150,000), and even the counseling office ($15,000). New studies indicate that thousands of other school districts will be forced to follow suit unless there is another federal infusion of cash. This is troubling because it sends a clear message to children that everything is for sale.

Didn't save for a rainy dayYet states have to assume their share of responsibility for the way they've used the $100 billion in federal stimulus funds they received soon after President Obama took office. Most of the money – $40 billion – was directed at shoring up the balance sheets of state education systems. The rest supported Title I funding for poor students, programs for disabled students, and smaller programs like the Obama administration's Race to the Top contest.

But according to a 50-state survey conducted by the National Conference of State Legislatures and reported in The New York Times, 20 states said they intended from the very outset to spend all of their stabilization funds in the 2008-09 and 2009-10 school years. On average, all 50 states spent 86 percent of the federal stimulus money in the past two years, leaving just 14 percent for this year. Such short-sighted budgeting in the midst of the Great Recession is hard to defend.

Whatever sympathy might be felt for schools in these hard times was further dampened by jaw-dropping examples of profligacy in other districts. The Los Angeles Unified School District (LAUSD), the nation's second largest, serves as a case study of how to undermine taxpayer confidence when it is desperately needed.

The district spent $578 million – or about $135,000 per student – to construct the Robert F. Kennedy Community Schools complex on the site of the former Ambassador Hotel. This amount made the project the most expensive school ever constructed in US history at a time when the district is flat broke. (Indeed, just last week, the LAUSD school board voted unanimously to seek corporate sponsorships to pay for school programs like sports, music, and art.)

Although the LAUSD committed to this project before the enormity of the recession became apparent, the Kennedy complex is only the latest in the district's building binge of 131 schools.It calls into question the way taxpayer money is spent. For example, The Wall Street Journal noted that another recently opened public school – the Visual and Performing Arts High School – was originally budgeted at $70 million. It ended up costing $232 million.

Nevertheless, voters in L.A. continue to approve such spending, in the process becoming enablers. Indeed, since 1997, they have OK'd more than $20 billion in school bonds. The only hard evidence of discontent is the support taxpayers have given to the establishment of charter schools. The LAUSD has more charter schools than any other school system in the country, enrolling about 9 percent of its students. Strictly from a financial viewpoint, charter schools are, without question, a bargain. They can be constructed for a quarter of the cost of most schools in the district.

Charter schools: great bang for the buckFor example, Green Dot Public Schools, a leading charter school operator in the L.A. area, has built seven schools there to serve 4,300 mainly low-income students for a total of less than $85 million. Its graduation rate is nearly twice that of the school district as a whole.

It's true that charter schools don't have to enroll special education students. But there's another factor given short shrift in the debate. Under Proposition 39, which was passed by California voters in 2000, districts are obligated to provide charter schools with facilities that are reasonably equivalent to those of other schools in the district.

About 60,000 students in the LAUSD attend charter schools. But administrators have dragged their feet on meeting the "reasonably equivalent" standard. They do so by denying charter schools the use of existing facilities. As a result, many have had to rent space. That eats up about 13 percent of their general funds on average, a recent Los Angeles Times commentary notes.

As long as lack of prudence characterizes fiscal policy, school districts everywhere will remain in dire straits. But let's not forget that, ultimately, voters possess the power to demand financial reform. If they don't, then they have no basis for complaint.

Chinese housing prices are on track to dip early next year, with tighter monetary policy and rising inventories combining to take some air out of a market that some fear could yet swell into a bubble. The government launched a campaign late last year to brake soaring property inflation, with the top-end sector in wealthy cities especially frothy. It succeeded for a while in stabilizing prices, but there have been signs of a pick-up in recent months.

Acutely aware of public anger over costly housing, Beijing will not stand for that. It will use higher interest rates, lending curbs and a battery of direct controls, from thwarting land speculators to levying a property tax, to deflate the real estate market. "The first half of next year will be a hard time for the property sector," said Chen Dongqi, deputy chief of the Macroeconomic Research Institute under the National Development and Reform Commission, China's powerful economic planning agency.

Property prices will fall in the first six months of 2011, though by less than 10 percent, said Liu Shiqing and Xu Shengli, analysts at Essence Securities in Beijing. "Under the impact of the macro policies, shares in developers face high risks in the next two quarters," they said in a note to clients. Chinese property shares .SSE have shed nearly 6 percent this week since the central bank raised interest rates, under performing the main index's fall of about 4 percent.

Official ResolveReal estate transactions and land prices have looked like rebounding in recent weeks, inviting the government to unveil fresh steps to cool the market at a time when the battle against inflation and asset bubbles is an official priority. Chinese Premier Wen Jiabao said on Sunday that he was not satisfied with the results of property tightening so far and voiced determination to pull housing prices back to a "reasonable" level within his term, which ends in early 2013. "Until now, the measures have not been implemented well enough, and we will reinforce our efforts in two ways," he told a radio broadcast.

That means, Wen said, that China will build more affordable housing and implement harsher monetary measures and stricter controls over land sales to curb speculation. Analysts also expect Beijing will start a trial programme of a long-awaited property tax in 2011 in a few key cities, including Shanghai and Chongqing, which will increase the cost of owning a residential unit.

Wen's pledge came a day after the central bank raised interest rates by 25 basis points on Christmas Day, its second time in just over two months. Economists polled by Reuters expected a further 50 basis points of rate rises in the first half. That will increase the cost of home purchases by 5 percent, according to calculations by China Real Estate Index System, a leading private research house.

No Relaxation"For most companies, liquidity conditions will get worse next year. For the residential housing segment, we will see more companies exit the industry as a result," said Feng Lun, chairman of Vantone Group, a leading Chinese property firm. China has already made it harder for developers to raise funds from banks, trusts and the stock market. Issuing bonds is also more costly, and the commerce ministry has recently erected extra barriers on foreign capital flows into the sector.

All that makes developers more dependent on sales. At the same time, about 1.2 billion square meters of residential property space now under construction will hit the market in the coming few months. That is about 45 percent more than the total sold so far this year, enough to tip the market into relative over-supply. Developers, especially those facing a cash crunch, will opt to cut prices.

Li Shaoming, an analyst at China Jianyin Investment Securities in Beijing, estimated that listed developers had enough cash to sustain operations for 10 months if transaction volume stopped growing. If it slowed, their financial cushion would deteriorate quickly, he added. Some firms have already kicked off promotional campaigns to boost sales.

"I'm receiving a growing number of new home ads sent to my mobile phone. Some offer a discount or part of the space like the balcony for free," Zhang Yafen, a women in her 40s. "But they are still unpardonable," she sighed. At current prices, she and her husband would need to save their full salaries for about 15 years just to make the down payment -- at least 1 million yuan -- on a three-bedroom unit in Beijing.

China is building more affordable housing for the country's ultra-poor. The target next year is 10 million units, up from this year's plan of 5.8 million. The country has completed 3.7 million units in 2010 so far, Premier Went said. "The issue now is how can we make the sector develop in a sustainable and healthy way," said He Qi, deputy secretary-general of the China Property Association.

Beijing city is to raise its minimum wage by 21 per cent next year, the second such rise in barely six months, amid rising inflationary pressure and growing concern over China’s widening wealth gap. The increase, which will come into effect on New Year’s Day, raises the statutory minimum monthly wage in the Chinese capital to Rmb1,160 ($175) and the hourly rate to Rmb6.7. It comes on the heels of a 20 per cent rise in June.

Every province and municipality in China has announced a rise in its minimum wage this year, with increases ranging from 12 per cent to Beijing’s 41 per cent. The official measure of annual consumer price inflation in China hit 5.1 per cent in November, up from 4.4 per cent in October, with food prices jumping 11.7 per cent in November from a year earlier.

The government is worried about the disproportionate burden of rising food costs on low-income households, which spend a larger share of their income on basic necessities. It also fears that persistent price rises could stoke social unrest, as they often have in the past.

"While China’s living standards have dramatically risen over the past 30 years, the gap between rich and poor has sharply widened," Yu Yongding, an influential former adviser to China’s central bank, wrote in an editorial last week. "With the contrast between the opulent lifestyles of the rich and the slow improvement of basic living conditions for the poor fomenting social tension, a serious backlash is brewing."

Nationwide increases in minimum wages are part of the government’s plan to reduce income disparity and the Chinese economy’s heavy reliance on investment and promote greater consumption by middle- and low-income households. But with many businesses already being squeezed by rising input costs, wage increases come at a difficult time and are likely to lead to higher overall inflation.

"In just the last three months we’ve already had to raise entry-level starting wages 60 per cent just to get people to come to a job interview," said Jade Gray, CEO of Gung Ho Pizza, a Beijing-based gourmet pizza delivery service. "With rising rents, the much higher cost of ingredients and now wage inflation, many businesses in the services industries are going to find it impossible not to pass on much higher costs to consumers."

With its latest wage increase Beijing now has the highest minimum wage in the country, just ahead of Shanghai on Rmb1,120 per month, but other cities and provinces, including the manufacturing hub of Guangdong, are already eyeing further increases early in the new year. The government estimates the latest rise in Beijing’s minimum wage will cost just over Rmb5bn and benefit nearly 3m people.

In the separately-ruled Chinese territory of Hong Kong, legislators in November set the city’s first-ever minimum wage at HK$28 an hour. The new wage, which takes effect in May 2011, followed months of public consultation and debate amid growing concern in the city about widening income disparities.

China's decision to raise interest rates to contain food and housing price increases is a missed opportunity to move the country toward a more domestic-oriented economy. All Beijing had to do was boost the value of the yuan, its national currency, to reduce the emphasis on its export sector, but there's no evidence that such a major change is likely.

Chinese Premier Wen Jiabao acknowledged on Sunday that China's inflation rate -- up 5.1% in November compared with a year ago -- "made life more difficult" for lower-income Chinese, the bulk of the nation's population. But he vowed that the government is "completely able to control the overall level of prices."

On the previous day, Christmas, China's central bank raised interest rates by 0.25% to 5.81%, the second increase in just two-and-a-half months. On Sunday, it also hiked mortgage rates by 0.25% to 4.30% for loans longer than five years in an effort to contain the country's overheated housing sector.

Where the Price Pressures AreJPMorgan Chase said in a note to clients on Sunday that it expects the Chinese to raise rates three times in 2011. But is this the best way to control inflation? Barry P. Bosworth, a senior fellow at the Brookings Institution, says increasing interest rates will have the same effect in China as it does in the U.S.: slowing demand. Some economists expect Chinese growth to fall to 9% or less in 2011 from 10% in 2010.

Bosworth says most of the price pressure is coming from wage increases in the coastal provinces, the home of China's export industries, where labor supply shortages are beginning to emerge, and from imported raw materials. "The easy way to control that is to shift the mix of production more toward continuing to stimulate domestic demand and rely less on the export sector," Bosworth says. "From the U.S. point of view, the way to do this is just let the exchange rate appreciate."

For the Yuan, a Scant Rise So FarBut Bosworth acknowledges that there appears to be a "big battle" within the Chinese government over whether to let the yuan appreciate against the dollar. Many Chinese exporters have complained that they'll be unprofitable if the exchange rate is allowed to climb, a threat that carries heavy weight with the government because it's concerned about a higher yuan's possible impact on unemployment.

But allowing the exchange rate to rise would reduce the cost of imported goods such as foodstuffs like soybeans, which would benefit all of China's economy. Raw materials would also be cheaper in domestic currency terms.

Yes, Beijing announced in June that it would allow the yuan to appreciate, but the currency has gained only around 3% against the dollar. Many economists in the U.S. believe the yuan is between 30% and 40% undervalued against the greenback.

One Positive DevelopmentThe higher interest rates mean depositors will get paid more for their money. The government hopes that will lure them away from making investments in the housing market, a main cause of inflation. But with inflation at 5.1% and the interest on deposits at 2.75%, depositors are still losing money by keeping their cash in the bank.

Bosworth does note one positive development from the interest rate hike: Beijing seems to be moving toward a market-based system of regulating monetary policy. In the past, government officials used to set different reserve requirements for banks and also set loan targets. "That's kind of an awkward way to run monetary policy in a more developed financial market," he says.

The Beijing government has expressed concern about "hot money" from abroad coming to China because of the higher interest rates. But, again, instead of allowing the yuan to appreciate, it's talking about imposing more controls on the flow of capital. Perhaps at some point, China will relent and let the yuan rise enough to have the desired cooling effect on the country's economy. That point isn't in sight yet.

China cut its quotas on first-half exports of rare-earth metals around 35%, a move likely to feed trade tensions and concerns among global buyers after an even deeper cut late this year. China supplies around 95% of the world's rare-earth metals, which are used in high-tech batteries, television sets, mobile phones and defense products. Beijing's decision to cut export quotas by 72% for this year's second half sparked criticism that China was taking undue advantage of its position to raise prices.

A supply crunch would have its deepest impact on Japanese technology manufacturers, such as Hitachi Ltd., but the problem extends further. Sumitomo Corp. and other companies process the metals and ship them world-wide, said Hallgarten & Co. strategist Christopher Ecclestone. Motors for Dyvacuum cleaners contain magnets made of neodymium, a rare-earth element, while such aerospace companies as Boeing Co. and Lockheed Martin use rare-earth materials for guidance systems.

China's export quotas are stoking trade tensions less than a month before Chinese President Hu Jintao visits with U.S. President Barack Obama. "We are very concerned about China's export restraints on rare-earth materials," a spokeswoman from the U.S. Trade Representative's office said Tuesday. "We have raised our concerns with China and we are continuing to work closely on the issue."

In trade talks this month, U.S. trade officials were unable to persuade China to ease restrictions on rare-earth metals, according to a USTR report to Congress released last week. The report said the U.S. will continue to press Beijing on the issue and would consider bringing the matter to the World Trade Organization. Xu Xu, president of the China Chamber of Minerals, Metals and Chemicals Importers & Exporters, said Tuesday it is legitimate for China to restrict exports of rare-earth metals and that such a policy doesn't violate WTO rules. Beijing has maintained that the export cuts are in line with sustainable development, citing concerns over environmental damage associated with mining the metals.

Quotas for the first half of next year will total 14,508 metric tons, down about 35% from a year earlier, China's Commerce Ministry said Tuesday. The reduction doesn't appear to jibe with comments from Commerce Minister Chen Deming, who said this month that China would leave quotas for the minerals largely unchanged next year. China in the past has adjusted second-half quotas after evaluating first-half figures and consulting with industry participants, so the quotas for all of next year could end up in line with this year's level. The ministry said Tuesday that it hasn't set a quota for the full year and cautioned against inferring the full-year figure from the first-half quota.

Shipments of rare-earth metals will be capped at 10,762 tons for 22 approved Chinese companies and at 3,746 tons for 10 approved foreign companies and joint ventures with foreign partners, according to the ministry's website. That represents 34% and 37% declines, respectively. Pingyuan Sanxie Rare Earth Smelting Co., which has foreign investors, was allocated 62 tons, subject to confirmation by the end of March. Rare-earth metals became a hot topic in September, when Japanese importers said China had suspended shipments of the metals.

In response to China's increasingly strict regulation of its rare-earths industry and soaring prices, major global consumers, such as Japan and the U.S. are seeking alternative suppliers, including Australia, Mongolia and Thailand. Japanese Prime Minister Naoto Kan in October agreed with Mongolian Prime Minister Sukhbaatar Batbold on a project to develop rare-earth metals in Mongolia. Sumitomo is developing a mine in Kazakhstan.

Australia's Lynas Corp. and U.S.-based Molycorp Inc. are ramping up production. Molycorp recently began blasting in an open-pit mine in the California desert that had been the world's dominant rare-earth supplier before mining stopped in 2002. Molycorp shares rose as much as 11% Tuesday morning before trading down for the day in late New York trading.

Chinese officials have said they welcome the additional production, saying it is irrational for China to supply the whole world's rare-earth needs with just 30% of global reserves. Diversifying supply is necessary, and "every country that has reserves should start to exploit their resources instead of relying on China," said Mr. Xu, of China's minerals chamber. He predicted that rare-earth prices will increase, in line with prices for most bulk commodities, including copper, oil and iron ore.

But China remains confident its dominance won't be easily eroded. "I am confident that China will hold its bellwether position in the global rare-earth industry in the long term," said Wang Caifeng, a former senior official with the Ministry of Industry & Information Technology's raw-materials department.

Japan's budget is in a truly terrifying state. Reading about the government's behavior reminds me of the worst accounts of compulsive spenders on the verge of personal bankruptcy--a sort of "What the hell, we're screwed anyway, so let's not think about it and maybe go to Cabo for the weekend." The budget's structural position is what is known technically to economists as "completely hosed"; borrowing now exceeds tax revenue, and debt service costs now eat up almost half of the tax revenue the government collects. "Unsustainable" is too weak to describe the situation; I don't know how they're doing it now.

To be sure, a lot of people have been awaiting the inevitable collapse of the Japanese government's finances for the better part of a decade. I know all the arguments for why this isn't such a big problem: their debt is financed domestically, much of it through the postal savings system that pays little for its borrowing, and the Japanese are extremely patriotic about their nation's financial needs. That may shift the locus of the problem, but it doesn't actually solve it; eventually, no matter how patriotic they are, the Japanese are going to want to use some of those savings to support themselves in their old age. Some sort of crisis virtually has to ensue.

When I was starting out as a journalist, I frequently had Japan used to illustrate Adam Smith's precept that "there's a lot of ruin in a nation"; any time someone was tempted to get hysterical about government borrowing in America or elsewhere, someone else would inevitably point out that Japan's debt burden was well over 100% of GDP, and the country still hadn't collapsed. But while there is a lot of ruin in a nation, there isn't actually an endless supply, and Japan may well be finally approaching the limits.

Felix Salmon views this as a symptom of a broader political failure:The situation in Japan is particularly depressing because the country has no major ethnic or political rifts. Sure, there's political jostling, both within and between the parties. But it's nothing compared to the vitriol and mistrust that we see in the US, and somehow I can't imagine Greece-style riots in Japan either. But still the technocrats can't make any headway.

The lesson here, I think, is that it's very, very hard for a government to enact a serious fiscal adjustment unless and until the bond market forces its hand. The Brits are trying, of course -- and we'll see whether or not the coalition government can succeed. But as we saw with George W Bush, the fiscal rectitude of one administration can be more than wiped out during the course of the next.

Even now, with the attention of the world more concentrated on sovereign fiscal issues than ever, the Japanese government can still contrive to raise agricultural subsidies by 40% and send child-care payments soaring, including payments to families who don't need the money. It's even getting rid of highway tolls. Oh, and it's cutting the corporate tax rate. From a bond-market perspective, this basically just means an ever-greater supply of JGBs: we're still a very long way from any real credit risk, given the political power of the owners of those bonds. But as a lesson in fiscal political economy, Japan is much more worrisome.

I see it a little bit differently: Japan has simply reached the limits of Keynesian policy in an economy which has never managed to jolt itself back up to a healthy rate of growth. Demographics is obviously a big contributor to that slow growth, and there are a whole host of secondary factors one could nominate, but whatever the reason, they have now had two decades of anemic growth, which they have fitfully attempted to address with stimulus. Maybe not enough stimulus, maybe badly designed, but they've certainly tried to follow the basic Keynesian playbook: borrow money and spend it when times are bad, in the hopes that you can bring back growth.

But for Japan, at least, the growth has not materialized. Few economists would advise undertaking a fiscal adjustment, on the scale that Japan requires, in the face of the current crisis. The problem is, there hasn't been a good time for retrenchment in 20 years. I can't blame the politicians for trying to restore some semblance of normal growth in the run-up to elections. But at some point, they're going to have to cut back, whether or not it's a good time.

Matt Yglesias suggest that it's irrational to retrench ahead of the bond market, when what they ought to be doing is trying to have more economic growth, but their lack of economic growth really isn't for lack of trying. I think every economist who has ever had an opinion on currency has been solicited, at one point or another, to come up with a plan for Japan, but they've all failed, either because the plans weren't politically feasible, or because the money supply simply stubbornly refused to inflate no matter how hard it was pumped.

Given the menu of actual policy options, it would probably be best for Japan to attempt fiscal adjustment now. The earlier you deal with a fiscal problem, the smaller the problem is . . . and doing it in advance gives you rather more discretion about how and when the cuts are made, which gives everyone, espeically the people who are now dependent on the government, time to adjust. But it's not hard to see why it hasn't. Which of us would volunteer to be the guy who cuts pensions and farm subsidies while there's a recession on?

Japan’s consumer prices fell for a 21st month in November, a sign sustained deflation may prompt the central bank to revise its price projections. Consumer prices excluding fresh food declined 0.5 percent from a year earlier, the statistics bureau said today in Tokyo. That compared with a median 0.6 percent drop predicted by 28 economists surveyed by Bloomberg News.

Entrenched deflation is weighing on an economy at risk of contracting this quarter as the effects of Prime Minister Naoto Kan’s stimulus spending fades. Miyako Suda, a Bank of Japan policy maker, said this month the persistent price falls will continue in the year starting April, an outlook that conflicts with the bank’s forecast of moderate inflation in the period.

"The BOJ will probably be forced to reconsider its price projections," Mari Iwashita, chief market economist at Nikko Cordial Securities in Tokyo, said before the report. "It’s highly likely that the period of deflation end will be pushed back further." The BOJ board forecast in October core prices will rise 0.1 percent next fiscal year and 0.6 percent the following year.

Also lowering the chance of an end to deflation is the rebasing of the price index next August, BOJ’s Suda said. The statistics bureau reshuffles the basket of goods used to measure CPI every five years, a move that Goldman Sachs Group Inc. estimates may lower the inflation rate by about 0.4 percentage point. The last government revision pushed down prices by about half a percentage point.

Cut Forecasts"Prices will keep falling, though the pace of declines will likely moderate," said Jun Ishii, chief fixed income strategist at Mitsubishi UFJ Morgan Stanley in Tokyo. "The BOJ will probably have to cut its consumer price forecast following a rebasing, which may intensify deflationary expectations."

The central bank in October reduced its key interest rate to the range of zero percent and 0.1 percent and pledged to maintain the policy until it can forecast stable price increases, which board members consider around 1 percent. Falling prices tend to erode corporate earnings, putting pressure on wages, weakening consumption and making debts harder to pay off. Deflation has afflicted Japan for more than a decade.

Companies are cutting prices to prompt penny-pinching consumers to loosen their purse strings. Zensho Co., a nationwide beef-bowl restaurant chain, this month lowered prices by 11 percent to increase sales, its third price-cut campaign this year.

Some of the world’s strongest banks have profited from an emergency credit facility set up by the US Federal Reserve to shore up confidence in the global financial system, according to a Financial Times analysis of data released by the Fed. More than half of lending under the Fed’s term auction facility – the largest of its crisis programmes – went to foreign banks. Details of the varied uses to which they put it may add to political criticism of the Fed.

The Taf was set up in December 2007 to provide one-month loans to creditworthy banks as markets dried up for lending longer than overnight. In August 2008, it began offering three-month loans as well. Rabobank of the Netherlands and Toronto-Dominion of Canada, two of the only banks in the world with triple A credit ratings, used more than $20bn in cumulative Taf loans. Ed Clark, TD chief executive, said that using Taf was logical even though his bank never had a liquidity problem. "That wasn’t how we made a lot of money. But you make a dollar here, you make a dollar there. What’s the spread you make on a billion dollars?" he said.

In the summer of 2008, TD was borrowing $1bn from TAF at rates of between 2 and 2.5 per cent. For that borrowing it used the lowest quality – and hence highest yielding – collateral acceptable to the Fed. More than 80 per cent of its collateral had a triple B credit rating at a time when such bonds yielded about 7 per cent. TD could therefore have made a notional gross spread of about $4m a month during 2008.

Mr Clark said the authorities were encouraging healthy banks to use schemes such as the Taf so as not to stigmatise their weaker counterparts. In January 2008, Ben Bernanke, the Fed chairman, said the Taf appeared to be succeeding because "there appears to have been little if any stigma". "You go through the whole crisis and there were lots of things we did that weren’t necessarily economic but were the right thing to do for the system," said Mr Clark. "So I’m not embarrassed by this at all."

Rabobank said it used the Taf only "in case the situation on the financial markets would further deteriorate" but it still had $5bn in outstanding loans as late as January 2010.The Fed declined to comment, but has pointed out that all of its emergency credit was repaid in full with interest, and that its goal was to provide liquidity. Korean banks, including Hana Bank, Korea Development Bank, Industrial Bank of Korea and Shinhan Bank, were also among the most enthusiastic posters of triple B collateral to the Taf. One Korean bank official said: "It was the best option we had for raising foreign capital during the financial crisis."

One of the big surprises when the US Federal Reserve was forced to publish details of the loans it made during the the 2007-2010 financial crisis was the heavy use of its schemes by foreign banks. This prompted a political backlash in the US. "We’re talking about huge sums of money going to bail out large foreign banks," said Bernie Sanders, the independent senator from Vermont. "Has the Federal Reserve of the United States become the central bank of the world?"

About 55 per cent of cumulative loans under the Term Auction Facility (TAF) – the largest crisis programme – went to US branches of foreign banks. Another 5 per cent went to US banks owned by foreign parents. German banks took about 15 per cent of total lending and UK banks about 12 per cent. But weighed against all Fed crisis facilities, the foreign share would be much lower, because many big US institutions, including Merrill Lynch, Morgan Stanley and Citigroup, used other schemes, such as the Primary Dealer Credit Facility, rather than the TAF.

There were three broad groups of foreign TAF users. The first included some of the world’s strongest banks such as Rabobank of the Netherlands and several large Canadian banks. They did not much need the liquidity. But TAF interest rates were low and the authorities were encouraging them to borrow, so they did. The second group included troubled institutions, some of them heavy investors in subprime securitisation markets, which urgently needed the liquidity that TAF provided. Some heavy users of the facility, such as Dexia of Belgium and HSH Nordbank of Germany, ended up needing state bail-outs.In 2008 Dexia borrowed more than $10bn from the TAF. About half of its collateral comprised asset-backed securities. Dexia eventually suffered a €3.3bn ($4.3bn) net loss for 2008, with heavy impairments on portfolios of US asset-backed securities, and was rescued by a €6bn government capital injection. Dexia declined to comment on the collateral it posted with the Fed. "The Fed played its role as central banker providing liquidity to banks that needed it," said Dexia.

HSH Nordbank used more than $50bn in cumulative TAF loans and much of its collateral consisted of asset-backed securities or commercial property loans. It did not respond to questions about its use of TAF. A former Fed official said many troubled institutions posted much more collateral than required by the rules. That limited the Fed’s risk. Dexia generally lodged $20-30bn more collateral than it needed to with the New York Fed. A final set of TAF users saw the programme mainly as a way to get hold of scarce dollars.

When the treaty establishing Europe’s common currency was approved in the early 1990s, Europe’s political and business elite had high hopes that it would bind the Continent’s disparate economies and often bickering nations as never before. And as the euro made its debut in the early 2000s, there was an outpouring of support from many citizens pleased that they would no longer have to change Spanish pesetas to French francs or Dutch guilders to German marks as they crossed borders from one country to another.

But not everybody was caught up in the celebration. A noisy band of dissenters, many of them economists from outside the Continent, issued a warning: the euro was doomed to struggle, they proclaimed, maybe not immediately but certainly before long. Different countries would pursue such different economic policies, they argued, that it would ultimately place an unbearable strain on the currency and some of its members.

Today, many of those predictions — handily dismissed at the time — are coming true. For most of 2010, Europe struggled to contain a debt crisis that has prompted investors to drive up the yield on government bonds. And despite two bailouts — for Greece and for Ireland — the anxiety has not dissipated, and attention has turned to other faltering economies like Portugal and Spain.

Last Friday, the cost of insuring Greek debt pushed higher on speculation that Athens might restructure its debt in 2013. That followed a warning on Thursday by Fitch, a major credit rating agency, that a downgrade of Greek debt was imminent. Fitch had already downgraded Portugal’s debt on concerns about its growth prospects and its ability to cut its deficit.

"I knew from the very beginning that putting all these heterogeneous countries together would not work," said Wilhelm Nolling, a member of Germany’s Bundesbank governing council before the establishment of the European Central Bank who is now a professor of economics at the University of Hamburg. If history is any guide, these critics say, even more troubles could be on the way. They point to a handful of little-known and less ambitious common currency efforts that failed in the past.

To be sure, Europe’s decision to embrace the euro was widely debated at the time, and even supporters worried that a monetary union without more political and social cohesion to back it up might founder. But the criticisms were glossed over in the euphoria at the end of the cold war and the hope that firm rules for countries joining the common currency would secure a unified economy and forge an unbreakable European identity.

The most forceful opposition was centered in Britain, which, along with Denmark, agreed to sign the Maastricht treaty in 1991 setting out the path to a European single currency only after insisting on the right to opt out of any final step. And it was not just the perennial euro skeptics of Britain’s Conservative Party who warned of troubles ahead. Ed Balls, then an obscure editorial writer for The Financial Times, wrote a report in 1992 identifying what he termed a crucial flaw in the plans for the euro: Europe lacked the type of federal taxes and transfer payments used in the United States to ease economic divergences among its many states.

Published by the Fabian Society, a left-of-center research group in London, the paper caught the eye of Gordon Brown, then shadow chancellor for the out-of-power Labour Party. Mr. Brown hired Mr. Balls and then seized on his core argument when the Labour Party gained power in 1997 to insist that Britain stick with the pound — despite general support for the euro from Prime Minister Tony Blair and a majority of the Labour Party hierarchy.

"Having the political will is not enough," Mr. Balls, who remains an important figure in the Labour Party, said in an interview. "You need a level of integration and commitment that goes well beyond that."

That it was a Labour and not a Tory government that kept Britain from joining the euro no doubt grates on the nerves of Britain’s traditional euro skeptics. For example, Norman Lamont, the former Conservative chancellor of the exchequer and the recognized leader of this pack, says he has "never heard of Balls’s paper."

Mr. Lamont, who as chancellor from 1990 to 1993 led the British side in the Maastricht negotiations and pushed for the provision to opt out of the currency, points instead to a speech he gave in November 1990 as the earliest and most specific public critique of plans to create the euro. "The fact is that Europe is not ready for a single currency," Mr. Lamont said in that speech, which came a month after Britain joined the exchange rate system in Europe that preceded the euro.

The address was intended to bolster the flagging fortunes of Prime Minister Margaret Thatcher, who was on the verge of being ousted as leader by a growing pro-Europe faction within the Conservative Party. Mr. Lamont highlighted the disparity in inflation, budget deficits and employment levels that separated poorer southern nations from core European economies. "So long as such divergence exists," he said, "a move to a single currency would represent a massive leap in the dark."

Mr. Lamont served as chancellor under Ms. Thatcher’s successor, John Major, presiding over the collapse of the pound and Britain’s humiliating expulsion from the exchange rate mechanism in 1992. As for his doubts about the euro, they have become even more pronounced. "I have always said that the euro will break up," Mr. Lamont said in a recent interview. "Not after the first crisis today, but after the second crisis, which could be 10 years away. This is, after all a political project, not an economic project."

Mr. Lamont points out that previous currency projects in Europe, like the Latin monetary union formed by France, Belgium, Italy and Switzerland in 1865 and a similar one in Scandinavia, by Sweden, Denmark and Norway in 1875, lasted more than 30 years before they collapsed. "The real problem is that the only way countries like Greece and Spain and Portugal can regain their competitiveness with Germany is to impose a decade of restrained living standards on their populations," he said. "That is the time bomb ticking inside the euro."

But for the euro’s defenders, this crisis pales in comparison to the 20th century wars that tore Europe apart and represents little more than a speed bump on the road to an even more united Continent. That view was put forward this month at the opening of the European Commission’s new representative office in London. Called Europe House, the building is the former Tory headquarters where Mrs. Thatcher, Britain’s most senior euro skeptic, celebrated three election wins — a footnote that European officials highlighted smugly during the evening’s festivities.

"We remember what happened in the last big crisis — it was something horrible, and such a threat is always waiting for us," said Jerzy Buzek, the former prime minister of Poland and current president of the European Parliament.

A glass of white wine in his hand, Mr. Buzek paid little mind to the notion that the current financial unrest in Europe would lead to the euro’s collapse. "Let us answer by having more solidarity," he said. "We are a beautiful, fantastic Europe, and overcoming history is an imperative for us."

Indeed, even in Ireland, which along with Greece has paid the steepest price for being tethered to the euro, economists are mostly uniform in their support of a single currency. They cite in particular the benefit of monetary stability and the fact that the euro zone has been saved from the harmful dynamic of competitive devaluations and capital controls that has flared up in emerging market economies.

"In an integrated world, having a common economic approach to policy has a lot of strength," said Philip R. Lane, an economist at Trinity College in Dublin who oversees the influential Irish Economy blog. But Mr. Nolling, the German economist, insists that whatever the euro’s supposed advantages, in practice European policy makers have gone too far in their effort to preserve the single currency. The financial rescues of Greece and Ireland, he contends, are "unconstitutional" because they violate the euro zone’s no-bailout clause.

Germany’s constitutional court is expected to rule on a case brought by Mr. Nolling and a group of like-minded economists and lawyers early next year. While few expect a decision that would reverse the Irish and Greek interventions, the challenge is a blunt reminder that Germany, the European nation with the deepest pockets, remains deeply divided over the merits of the single currency and that further financial rescues could face many obstacles, both political and legal.

"We were told that the euro would achieve peace in Europe forever," Mr. Nolling said, "but I am sad to say that the opposite is true."

European companies’ relative cost of borrowing has risen above that of US groups for the first time since the financial crisis as the worries about sovereign debt in the eurozone hit businesses. Debt issued by European companies has historically traded lower compared with government benchmark rates than that of their US rivals. But since the end of November, European companies have started paying a higher premium, according to Bank of America Merrill Lynch corporate debt indices.

The data suggest European companies are starting to pay the price for the sovereign debt crisis that has hit countries such as Greece, Ireland and Spain. It comes at the same time as growth prospects in the US have improved. "European credit will continue to struggle versus the US market in the coming months in our view. Problems in the periphery will not go away in the new year," said Teo Lasarte, European credit strategist at BofA Merrill Lynch.

European companies on December 21 paid an average premium of 1.89 percentage points over benchmark government rates, compared with 1.69 percentage points for US groups. That 0.20 percentage points differential was the largest on record, as European groups have historically paid lower premiums because of differences in their debt structure.

The differences are even more pronounced in credit default swaps, used by investors to protect themselves against the risk of bankruptcy at a company. US and European CDS indices were roughly the same at the start of September but have diverged wildly since then. The US investment-grade five-year CDS index has fallen from about 105 to 85 over the period, while the iTraxx Europe five-year index has stayed flat at 105.

The differences suggest investors are pricing in higher default risk and are less willing to lend to European companies than US rivals. "Looking at the CDS indices, there has been a sharp underperformance of European credit versus the US recently," said Mr Lasarte.

The situation is even worse at companies and banks located in peripheral eurozone countries as many have, in effect, been shut out of the market. One of the worst performers in recent weeks has been Enel, the Italian utility that has a large debt burden following the purchase three years ago of Endesa, its Spanish electricity group. Spain’s soaring financing costs have caused it to postpone plans to repay utilities billions of euros it owes them, sparking Moody’s, the rating agency, to place Enel on review for a possible downgrade.

Italy's borrowing costs have jumped to the highest level since the financial crisis over two years ago, raising concerns that Europe's biggest debtor may slip from the eurozone's stable core into the high-risk group on the periphery.

Yields on 10-year bonds rose 10 basis points to 4.86pc after a poor auction of short-term debt in Rome. The Italian treasury had to pay 1.7pc to sell €8.5bn (£7.2bn) of six-month bills in a thin post-Christmas market, up from 1.48pc a month ago. The spike in rates came as money supply data released by the European Central Bank showed that real M1 deposits have collapsed at a rate of 2.8pc over the last six months in the EMU bloc of Italy, Spain, Greece, Ireland and Portugal, even though they are rising in northern Europe.

"This is comparable with the decline in early 2008 just ahead of the plunge into recession," said Simon Ward from Henderson Global Investors. "The eurozone periphery is locked into a 'double dip' that will undermine fiscal consolidation." Italy's M1 contraction began later than elsewhere in southern Europe but is now accelerating. M1 typically gives advance warning of economic shifts by six to nine months. Mr Ward said signs of recovery in the ECB's broader M3 money data is less reassuring than it looks since the gauge was temporarily boosted by flight to liquid assets on EMU debt worries.

The poor auction in Rome may be a warning sign that EU leaders offered too little to restore confidence at their Brussels summit two weeks ago. German Chancellor Angela Merkel vetoed the creation of eurobonds or any serious move towards fiscal union, and shot down calls for an increase in the eurozone's €440bn emergency loan fund. The ECB has so far refused to step in to the breach with overwhelming action.

Willem Buiter, Citigroup's chief economist, said the response had been "woefully inadequate", raising the risk of fresh bank failures and a wave of sovereign defaults next year. He said the EU authorities may need a mix of measures worth up to €2 trillion to stop the rot. Italy avoided the sort of property bubble seen in Spain or Ireland and has kept a tight rein on public spending under finance minister Giulio Tremonti. However, the rise in yields looks ominously like the pattern seen in Greece, Ireland, Portugal and Spain when they first began to lose easy access to the capital markets.

Neil Mellor, currency strategist at the Bank of New York Mellon, said big institutional investors have been pulling funds out of Italy and rotating into German debt on a large scale. "Our flow data shows that the trend has been just as concerted out of Italian debt as it has been out of Irish or Greek debt. Italy should be able to weather 2011 in good shape but the government's debt dynamics are very poor," he said.

Italy is too big to be rescued by a diminishing group of creditor states in the EMU core, should it ever need help. Public debt will creep up to 120pc of GDP next year – or over €1.9 trillion – a level widely seen as the outer limit of debt sustainability. The country's trump card is a high savings rate and low private debt. Total debt is 245pc of GDP, below the eurozone average, and much lower than in Spain, Britain, the US or Japan. This may be the relevant indicator for an economy as a whole. However, low private debt may equally reflect deep pessimism in a country where growth has been glacial for a decade, productivity has fallen since 1995, and global export share is in steep decline.

Almost a quarter fewer shoppers turned out to grab a bargain in the traditional Boxing Day retail sales compared with last year, a survey by Synovate Retail Performance said on Monday.

The total number of shoppers fell by 22.8pc nationally on the day after Christmas Day, although stores in London attracted 11.4pc more visitors, Synovate said. Shopper numbers were down by as much as 27pc in southwest England and by 19.9pc in eastern England. Britain's retailers are striving to sell as much as possible over the Christmas and New Year holiday period, since many expect sales to decline next year due in part to a rise in Value Added Tax (VAT) which takes effect on Jan. 4.

Nearly two-thirds of retailers expect sales next year to fall compared with 2010, as weak consumer confidence and inflationary pressures come to bear, according to a survey conducted by the British Retail Consortium (BRC). In a bearish prognosis for the retail sector, just 18pc of businesses expect sales to improve in 2011, compared with 64pc who expect a deterioration.

Shops have already been hit by the appalling December weather, Synovate reporting yesterday that retail forecasts for the month have undersestimated the drop in customer numbers caused by the snow. The research company had previously estimated a 4pc drop in shoppers, but footfall between December 22 and 24 was down 6.1pc compared with last year.

"Retailers expect a difficult December to be followed by a tough 2011," said Stephen Robertson, director general of the BRC. "They believe the VAT rise will contribute to higher prices and, with fears about government cuts and the wider economy, people will be put off spending."

Reports on Sunday of record Boxing Day retail sales of £2bn were not a sign that the sector would continue to perform well, economists said. "Many shops will have a lot of stock to shift that they were unable to get rid of before Christmas due to the bad weather, so discounts may be more generous than usual," said Howard Archer, of IHS Global Insight.

"The likelihood is that consumer spending will be limited in 2011. Consumer confidence is currently low while the substantial fiscal squeeze will increasingly hit consumers’ pockets." Despite the downbeat forecasts many retailers expect to take steps towards growth next year. Some 41pc said in the BRC survey that they would raise investment and 47pc expected to employ more staff.

The Bank of Nova Scotia is sometimes praised for having a nearly perfect record with its investments in the United States. But it is the only one of Canada’s five large banks that has largely avoided the American market. Stephen Harper, the prime minister of Canada, is among the many Canadians who regularly remind the world that their country’s banking system was left largely unscathed by the global recession and credit market collapse because of its regulation and prudent management.

Now several of the banks are taking advantage of their solid balance sheets as well as the current revamping and consolidation of the American banking system to again look south for expansion. Last week, the Toronto-Dominion Bank agreed to pay $6.3 billion for Chrysler Financial. And earlier this month the Bank of Montreal bought Marshall & Ilsley, a bank based in Milwaukee, for $4.1 billion.

Given the uneven success of previous forays south of the border, however, few investors expect much good to come of either deal. "We don’t think it’s a great idea for Canadian banks to be expanding into the American market," said J. Bradley Smith, the head of research at Stonecap Securities in Toronto. "From a cultural perspective, we’re very similar. But from a management perspective, the American market is not an easy threshold to cross."

Still, Canadian banks have few other options for expansion. "The banks simply have no choice," said Louis Gagnon, an associate professor of finance at Queen’s University in Kingston, Ontario. "They have to go beyond our borders to grow and the only market that makes sense is the United States."

In their home market, Canada’s top five banks — the Royal Bank of Canada, the Toronto-Dominion Bank, the Bank of Nova Scotia, the Canadian Imperial Bank of Commerce and the Bank of Montreal — offer a complete range of banking, from retail to investment banking through a nationwide chain of branches. Changes in regulation have also allowed them to expand, on a limited basis, into insurance while most brokerage houses became bank subsidiaries.

That market dominance, and some regulatory restrictions, mean that competition from foreign-owned banks in Canada is limited. At the same time, the managers of Canadian banks are immune from takeover pressures because of federal laws that prohibit any person or company from owning more than 20 percent of a chartered bank. While that has made for a orderly financial system for Canada that is very profitable for bank investors, the banks now find themselves accumulating substantial capital without effective ways to use it to increase their businesses within Canada.

The recent rise of consumer debt in Canada has added to the problem. Mark J. Carney, the governor of the Bank of Canada, suggested this month that it had become time for banks to restrict consumer lending, a proposal later echoed by Jim Flaherty, Canada’s minister of finance. The United States looks like an enticing market, but as Professor Gagnon said, the results have historically been uninspiring.

By most estimates, the Canadian Imperial Bank of Commerce has fared poorest in the United States. In 2007, burdened by claims from Enron investors against its American unit, the bank sold the bulk of its United States operations to Oppenheimer Holdings. The Royal Bank of Canada’s RBC Centura unit, which is mainly active in the southeastern United States, Toronto-Dominion’s TD Banknorth, which covers the Northeast, and the Bank of Montreal’s Harris Bank, based in Chicago, have not been similar experiences. But they are all consistent underperformers relative to their parent companies’ operations in Canada.

Toronto-Dominion has been the most aggressive in the United States recently. Ed Clark, its chief executive, has exported a formula that he used to substantially increase Toronto-Dominion’s lucrative retail business after it acquired Canada Trust, which he previously headed, in 2000. In short, it emphasizes improvements in customer service like longer business hours. Whether that plan will succeed remains to be seen, but Canada’s banks are not the only Canadian companies that have found that their success at home do not necessarily translate to the large and more competitive environment of the United States.

For example, Tim Hortons, the doughnut and coffee shop chain, dominates Canada’s fast-food market to a degree without a parallel in the United States and successfully opens new stores rapidly. But continuing struggles with its American expansion forced the closing of 54 outlets in New England last month. Regardless, James L. Darroch, the director of the financial services program at the Schulich School of Business at York University in Toronto, said that the revamping of the American financial sector would most likely force Canadian banks to increase their investments in the United States.

"Either you’ve got to expand in the U.S. to become profitable or you’ve got to exit," he said. "If you want to stay in that market, now’s the opportunity to shape it. The question is: 'Can you do it right?’ "

Uniquely, the Bank of Nova Scotia has looked outside of the United States for its growth and expansion, primarily to Latin America and China. While that strategy has brought some missteps, particularly during Mexico’s currency crisis, it has generally been more fruitful than its competitors’ efforts in the United States. The downside of Nova Scotia’s approach, said Professor Gagnon, who is a former senior manager at the Royal Bank, is that those markets usually take much longer to develop and do not afford the large takeover opportunities that are readily available in the United States.

While Mr. Smith, the analyst, is skeptical about further expansion by Canadian bankers in the United States, he has high praise for their skills, particularly in areas like risk management. "I feel for the managers of Canadian banks because they’re under a lot of pressure from analysts and investors," he said. "But the success of Canadian companies in general, even beyond banks, in expanding into the U.S. is pretty spotty over the long haul."

Wall Street’s biggest banks, whose missteps caused a global financial crisis and economic slowdown two years ago, were more agile when it came to countering the political and regulatory response.

The U.S. government, promising to make the system safer, buckled under many of the financial industry’s protests. Lawmakers spurned changes that would wall off deposit-taking banks from riskier trading. They declined to limit the size of lenders or ban any form of derivatives. Higher capital and liquidity requirements agreed to by regulators worldwide have been delayed for years to aid economic recovery.

"We continue to listen to the same people whose errors in judgment were central to the problem," said John Reed, 71, a former co-chief executive officer of Citigroup Inc., who estimated only 25 percent of needed changes have been enacted. "I’m astounded because we basically dropped the world’s biggest economy because of an error in bank management."

The last two years have been the best ever for combined investment-banking and trading revenue at Bank of America Corp., JPMorgan Chase & Co., Citigroup, Goldman Sachs Group Inc. and Morgan Stanley, according to data compiled by Bloomberg. Goldman Sachs CEO Lloyd Blankfein, 56, and his top deputies are in line to collect more than $100 million in delayed 2007 bonuses -- six months after paying $550 million to settle a fraud lawsuit related to the firm’s behavior that year.

Citigroup, the bank that needed more taxpayer support than any other, has a balance sheet 14 percent bigger than it was four years ago.

Army of LobbyistsWall Street’s army of lobbyists and its history of contributions to politicians weren’t the only keys to success, lawmakers, academics and industry executives said. The financial system’s complexity gave bankers an advantage in controlling the narrative and dismissing the ideas of would-be reformers as infeasible or dangerous. A revolving door between government and banking offices contributed to a mind-set that what’s good for Wall Street is good for Main Street.

To make their case, bankers and lobbyists characterized proposed regulations as stifling innovation, competitiveness and economic growth. They said the industry had learned its lessons and that firms were adopting changes voluntarily to be more transparent and accountable. Successful companies shouldn’t be punished for the sins of those that failed, they said.

"It is important to look beyond the rhetoric and ask the tough questions about underlying structural changes that promote responsible reforms and stability to our financial system, yet support the ability of financial firms to innovate and serve the needs of families and employers," Timothy Ryan, CEO of the Securities Industry and Financial Markets Association, an industry lobbying group, wrote in a Feb. 5 op-ed piece for the Washington Post.

'Culture of Greed’That argument resonated with lawmakers under pressure to boost a fragile economy and bring down an unemployment rate that has hovered near 10 percent since August 2009, its highest level in more than a quarter of a century.

"The big financial industry has convinced a lot of people, particularly in Congress and on the regulatory side, that they bring value to the economy with new instruments and new approaches," said Byron Dorgan, a Democratic senator from North Dakota who is retiring this year. "Anybody who wants to do things that seem aggressive is called a radical populist."

U.S. President Barack Obama was elected in 2008, weeks after Lehman Brothers Holdings Inc. collapsed in the largest bankruptcy and the Federal Reserve and government provided unprecedented support to insurance company American International Group Inc. as well as nine of the largest banks. Obama, who raised $15 million on Wall Street, promised that his administration would "crack down on the culture of greed and scheming" that he said led to the financial crisis.

Geithner, SummersWhile Obama vowed to change the system, he filled his economic team with people who helped create it.

Timothy F. Geithner, 49, who had been responsible for overseeing banks including Citigroup while president of the Federal Reserve Bank of New York, became Treasury secretary and named a former Goldman Sachs lobbyist as his chief of staff. Lawrence H. Summers, 56, who is stepping down as Obama’s National Economic Council director, opposed derivatives regulation and supported the 1999 repeal of the Depression-era Glass-Steagall Act, which separated commercial and investment banking, when he served as deputy Treasury secretary and Treasury secretary in President Bill Clinton’s administration.

'Free Pass’"It was very clear by February 2009 that the banks were going to get a free pass," said Simon Johnson, a former chief economist for the International Monetary Fund who is now a professor at the Massachusetts Institute of Technology’s Sloan School of Management. "You could see from the hiring of Tim Geithner and from the messages that he and his team were putting out that this was going to go very badly."

Even when changes were advocated by people who couldn’t be characterized as radical populists, their ideas were dismissed as unrealistic, misinformed, advancing ulterior motives or damaging to U.S. competitiveness. Such tactics helped bat back suggestions from billionaire hedge fund manager George Soros and Berkshire Hathaway Inc. Vice Chairman Charles Munger that regulators ban purchases of so- called naked credit-default swaps -- contracts that allow speculators to profit if a debt issuer defaults.

Geithner was an early opponent of any such ban, arguing at a March 2009 House Financial Services Committee hearing that it wasn’t necessary and wouldn’t help. "It’s too hard to distinguish what’s a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome," he said.

'Unbelievably Complicated’Dorgan, 68, who offered an amendment to the Dodd-Frank bill that would have banned such swaps and who wrote a 1994 article for Washington Monthly warning about the dangers posed by over- the-counter derivatives, said supporters in Congress backed down because they didn’t get pressure from their constituents. "The debate that’s necessary on these subjects is a debate that is so unbelievably complicated that the larger financial institutions have always controlled the narrative," Dorgan said. "Even things that were fairly mild were contested as anti-business and going to injure and ruin the economy."

Instead Dodd-Frank gave regulators at the Commodity Futures Trading Commission and the Securities and Exchange Commission the responsibility of writing rules governing the $583 trillion market in over-the-counter derivatives. The law, named after Connecticut Senator Christopher Dodd and Massachusetts Representative Barney Frank, requires that most derivatives be traded on third-party clearinghouses and regulated exchanges.

Private SwapsThe CFTC withdrew a proposed rule on Dec. 9 after at least one commissioner, Scott O’Malia, a former aide to Republican Senator Mitch McConnell, objected. The rule would have required dealers of private swaps to quote prices to all market users before trades could be executed on an electronic system. A new version, approved Dec. 16, will save dealers billions of dollars, according to Moody’s Investors Service, because they will be able to limit price information to select participants.

An amendment requiring banks to spin out their swaps- dealing operations into separately capitalized units, so they wouldn’t have access to government backstops, made it into the Dodd-Frank bill. It was diluted at the end to exempt interest- rate and foreign-exchange contracts that make up more than 90 percent of the derivatives held by U.S. banks.

Banks were also allowed to trade derivatives used to hedge their own risks and given up to two years to trade other types of derivatives, such as credit-default swaps that aren’t standard enough to be cleared through a central counterparty.

Too BigA suggestion that banks deemed too big to fail should be broken up or made small enough to fail -- an idea backed by former Federal Reserve Chairman Alan Greenspan, Bank of England Governor Mervyn King and hedge-fund manager David Einhorn -- also failed to win support from U.S. policy makers, as bank executives argued that size alone didn’t make a company risky and that it could be essential for banks to compete.

Jamie Dimon, JPMorgan’s CEO, said in a January 2010 interview that most of the financial firms that collapsed during the crisis were narrowly focused investment banks, insurers, mortgage brokers or thrifts, not big integrated conglomerates. "A lot of companies are big because they’re required to be big because of economies of scale," he said.

Glass-SteagallThe closest the Obama administration came to trying to limit the size of banks was in January, when the president proposed levying a fee on financial firms with assets of more than $50 billion. The idea was never adopted by Congress. Instead, it supported Geithner’s plan for a so-called resolution authority that would give regulators the ability to manage an orderly wind-down of a large financial company. Critics say the authority is unlikely to work in practice because regulators won’t have power over a bank’s international operations.

"The resolution authority as drawn up by Dodd-Frank does not apply to the megabanks and doesn’t apply to JPMorgan Chase, nor can it because that authority only applies to U.S. domestic financial entities," said MIT’s Johnson. "If anything, it’s gotten worse because we have fewer big banks. The ones that remain are undoubtedly too big to fail."

Even before Obama took office in January 2009, former Federal Reserve Chairman Paul A. Volcker, an economic adviser to the president-elect, was calling for clear distinctions between banks that take deposits and make loans and those that engage in riskier capital markets businesses. The recommendation, a modern version of Glass-Steagall, was put forward in a report by the Group of 30, an organization of current and former central bankers, financial ministers, economists and financiers whose board Volcker chairs.

Volcker RuleReed, the former Citigroup co-CEO, and David Komansky, a former CEO of Merrill Lynch & Co., were among those who said publicly that they regretted having played a role in overturning Glass-Steagall. Both of their former companies were crippled by investments in mortgage-linked securities during the crisis, and Merrill was sold to Bank of America in a hastily reached agreement the same weekend Lehman Brothers went bankrupt.

"We have to think of the original reasons why Glass- Steagall was brought down in the first place, and that is the U.S. banks were competing with large, universal banks around the world," Goldman Sachs CEO Blankfein said in a March 2009 interview with Bloomberg Television. "So I don’t think we’d turn the clock back."

The idea was left out of Geithner’s original financial regulation proposals and didn’t gain much support until January, after a Republican upset a Democrat in a Massachusetts senate race. Obama and his economic team, including Volcker, then announced they were supporting a so-called Volcker rule that would ban proprietary trading at regulated banks and prohibit them from owning hedge funds and private equity funds.

Proprietary TradingE. Gerald Corrigan, a former New York Fed president who worked under Volcker at the Fed and is now a managing director at Goldman Sachs, told a Senate hearing that banks shouldn’t be prevented from owning and sponsoring hedge funds or private equity funds because they promote "best industry practice." He urged a distinction between proprietary trading and "market making" for clients or hedging related to such market making.

In the final version of Dodd-Frank, the Volcker rule ended up looking much more like the Corrigan rule. Banks were allowed to own or sponsor hedge funds and private equity funds and even to invest in them as long as their holdings didn’t account for more than 3 percent of the bank’s capital or 3 percent of the fund’s capital.

The ban on proprietary trading exempted dealing in government and agency securities. Regulators were charged with deciding what other types of trading would be considered proprietary and which would be deemed market-making. Volcker was disappointed with the final version, according to a person with knowledge of his views.

Dodd-FrankGoldman Sachs Chief Financial Officer David Viniar, who told analysts in January that "pure walled-off proprietary trading" accounted for about 10 percent of the firm’s revenue, said in October that the company had closed one such business and was waiting to see if the rules would require other changes.

While the Dodd-Frank Act is the most sweeping financial legislation in decades, creating a consumer-protection office for financial products and a council of regulators charged with monitoring systemic risk, it won’t fundamentally change a U.S. banking system dominated by six companies with a combined $9.4 trillion of assets, MIT’s Johnson said.

'Falls Short’The law won’t prevent lenders with federally guaranteed deposits from gambling in the derivatives markets, though it will place restrictions on some types of contracts and require more transparent trading and central clearing. It does little to solve the danger posed by leveraged firms reliant on fickle markets for funding."It’s not my point to say that the legislation enacted is worthless," said Dorgan. "It requires more transparency and disclosure and a series of things that are useful, even though it falls short of what I think should have been done."

The Treasury Department takes a more positive view. The law "fundamentally changes the landscape of our financial regulatory system for the better," said Steven Adamske, a Treasury spokesman, in an e-mailed statement.

"The Obama administration and Secretary Geithner fought hard to enact a tough set of reforms that reins in excessive risk on Wall Street, protects the economic security of American families on Main Street, and makes certain taxpayers are never again put on the hook for the reckless acts of a few irresponsible firms," Adamske said. "It also creates a safer, more transparent derivatives market through comprehensive reform, bans risky pay practices, and it puts in place the strongest consumer protections in history."

2,300 ReasonsThe biggest financial companies increased their spending on lobbying in the first nine months of 2010 as they sought to influence the legislative outcome, according to Senate records. JPMorgan’s advocacy spending grew 35 percent, to $5.8 million from $4.3 million, while Goldman Sachs’s jumped 71 percent to $3.6 million.

Banks had "2,300 pages worth of reasons" for spending, said Scott Talbott, a lobbyist at the Financial Services Roundtable, which represents the largest lenders and insurance firms, referring to the size of the Dodd-Frank bill. "The issues on Capitol Hill required more attention."

'Always There’Spending during 2010 probably played only a small role in the ability of financial companies and trade groups to influence legislators, according to Anthony J. Nownes, a political science professor at the University of Tennessee in Knoxville whose books on the role of lobbyists include "Total Lobbying: What Lobbyists Want (and How They Try to Get It)" (Cambridge University Press).

"The idea that they stepped up their activity has some truth, but the larger truth is that they always spend a lot of money and this was no exception," Nownes said. "They’re always there, their viewpoints are always heard and it is a cumulative effect -- they’ve been saying the same things for years and years and years."

Even as they were spending more on lobbying, the largest U.S. banks cut their political giving for the 2010 elections. Of the 10 biggest financial firms, only Goldman Sachs, MetLife Inc. and the U.S. subsidiary of Deutsche Bank AG spent more from their political action committees during the 2009-2010 election cycle than they did in 2007-2008, according to Federal Election Commission filings. Talbott said the decrease was partly because of the economic slump, and also because some members of Congress refused to take donations from banks that received federal funds during the crisis.

Orszag, LubkeThe financial industry is adept at hiring people with experience in Congress and government, which gives it an edge in understanding the best tactics to use, Nownes said. This month Citigroup recruited former Obama administration budget director Peter Orszag as a vice chairman in its global banking business, and Goldman Sachs hired Theo Lubke from the New York Fed, where he oversaw efforts to make the derivatives market safer.

Research shows that lawmakers are more susceptible to lobbying on issues that are complex, technical or economic, which benefits the banks, Nownes said. "This certainly was a huge advantage for them, especially in designing some of the more intricate details of this piece of legislation," he said. "The more technical and complex, the bigger the informational advantage they have."

Tax on BonusesEven in areas that weren’t technical, such as bonuses, the financial industry was able to resist tough regulation. With polls showing strong popular support for limits on pay, former British Prime Minister Gordon Brown pressed for a tax on banker bonuses and one on financial transactions to deter speculative trading.

Obama didn’t go that far. Instead, the administration appointed Washington lawyer Kenneth Feinberg to review pay for the 100 top executives at firms receiving "exceptional assistance" from the Troubled Asset Relief Program. Feinberg ordered cuts at Bank of America, Citigroup and AIG, as well as at two bankrupt car companies and their finance divisions.

The administration, while opposing any pay caps, urged regulators to require changes that would better align compensation with risk, such as paying bonuses in restricted stock. Several banks responded by raising bankers’ salaries. So far this year, five Wall Street banks -- Bank of America, JPMorgan, Citigroup, Goldman Sachs and Morgan Stanley -- have set aside more than $91 billion for salaries and bonuses.

Money 'Paralyzes’In early 2010, Virginia Senator James Webb and California Senator Barbara Boxer, both Democrats, proposed an amendment to a jobs bill that would have imposed a 50 percent tax on any bonuses above $400,000 collected in 2009 by executives at banks that received at least $5 billion in TARP funds.

The U.S. Chamber of Commerce, which opposed the tax, urged senators to reject the idea because it "would likely hamper efforts to resolve the ongoing financial crisis, restore economic growth, spur job creation and is likely unconstitutional." The bill never made it to a vote.

"Neither party wanted to touch that issue," Webb said at the Washington Ideas Forum on Oct. 1. "Quite frankly, the way that money affects the political process sometimes paralyzes us from doing what we should do."

In a Bloomberg News National Poll conducted Dec. 4 through Dec. 7, 71 percent of Americans said big bonuses should be banned this year at Wall Street firms that took taxpayer bailouts, and 17 percent said bonuses above $400,000 should be subject to a one-time 50 percent tax. Only 7 percent of the respondents said they consider bonuses a reflection of Wall Street’s return to health and an appropriate incentive.

Protecting StockholdersReed, the former Citigroup executive, said he didn’t understand why lawmakers gave so much credit to arguments made by financial-industry participants whose job it is to put the interests of their shareholders above any concern for the safety of the financial system. "I’m surprised that the people in Washington think that the stockholders are the people that they should protect," Reed said. "It would seem to me that the people who should be protected are the overall banking system and the many, many, many companies that depend on it."

Two years before the financial crisis hit, Merrill Lynch confronted a serious problem. No one, not even the bank's own traders, wanted to buy the supposedly safe portions of the mortgage-backed securities Merrill was creating.

Bank executives came up with a fix that had short-term benefits and long-term consequences. They formed a new group within Merrill, which took on the bank's money-losing securities. But how to get the group to accept deals that were otherwise unprofitable? They paid them. The division creating the securities passed portions of their bonuses to the new group, according to two former Merrill executives with detailed knowledge of the arrangement.

The executives said this group, which earned millions in bonuses, played a crucial role in keeping the money machine moving long after it should have ground to a halt.

"It was uneconomic for the traders" -- that is, buyers at Merrill -- "to take these things," says one former Merrill executive with knowledge of how it worked.

Within Merrill Lynch, some traders called it a "million for a billion" -- meaning a million dollars in bonus money for every billion taken on in Merrill mortgage securities. Others referred to it as "the subsidy." One former executive called it bribery. The group was being compensated for how much it took, not whether it made money.

The group, created in 2006, accepted tens of billions of dollars of Merrill's Triple A-rated mortgage-backed assets, with disastrous results. The value of the securities fell to pennies on the dollar and helped to sink the iconic firm. Merrill was sold to Bank of America, which was in turn bailed out by taxpayers.

What became of the bankers who created this arrangement and the traders who took the now-toxic assets? They walked away with millions. Some still hold senior positions at prominent financial firms.

Washington is now grappling with new rules about how to limit Wall Street bonuses in order to better align bankers' behavior with the long-term health of their bank. Merrill's arrangement, known only to a small number of executives at the firm, shows just how damaging the misaligned incentives could be.

The mortgage securities business was supposed to have a firewall against this sort of conflict of interest.

Banks like Merrill bought pools of mortgages and bundled them into securities, eventually making them into CDOs. Merrill paid upfront for the mortgages, but this outlay was quickly repaid as the bank made the securities and sold them to investors. The bankers doing these deals had a saying: We're in the moving business, not the storage business.

Executives producing the securities were not allowed to buy much of their own product; their pay was calculated by the revenues they generated. For this reason, decisions to hold a Merrill-created security for the long term were made by independent traders who determined, in essence, that the Merrill product was as good or better than what was available in the market.

By creating more CDOs, banks prolonged the boom. Ultimately the global banking system was saddled with hundreds of billions of dollars worth of toxic assets, triggering the 2008 implosion and throwing millions of people out of work and sending the global economy into a tailspin from which it has not yet recovered.

Executives who oversaw Merrill's CDO buying group dispute aspects of this account. One executive involved acknowledges that fees were shared, but says it was not a "formalized arrangement" and was instead done on a "case-by-case basis." Calling the arrangement bribery "is ridiculous," he says.

The executives also say the new group didn't drive Merrill's CDO production. In fact, they say the group was part of a plan to reduce risk by consolidating the unwanted assets into one place. The traders simply provided a place to put them. "We were managing and booking risk that was already in the firm and couldn't be sold," says one person who worked in the group.

A month before the group was created, Merrill Lynch owned $7.2 billion of the seemingly safe investments, according to an internal risk management report. By the time the CDO losses started mounting in July 2007, that figure had skyrocketed to $32.2 billion, most of which was held by the new group.

The origins of Merrill's crisis came at the beginning of 2006, when the bank's biggest customer for the supposedly safe assets -- the giant insurer AIG -- decided to stop buying the assets, known as "super-senior," after becoming worried that perhaps they weren't so safe after all.

The super-senior was the top portion of CDOs, meaning investors who owned it were the first to be compensated as homeowners paid their mortgages, and last in line to take losses should people become delinquent. By the fall of 2006, the housing market was dipping, and big insurance companies, pension funds and other institutional investors were turning away from any investments tied to mortgages.

Until that point, Merrill's own traders had been making money on purchases of super-senior debt. The traders were careful about their purchases. They would buy at prices they regarded as attractive and then make side bets -- what are known as hedges -- that would pay off if the value of the securities fell. This approach allowed the traders to make money for Merrill while minimizing the bank's risk.

It also was personally profitable. Annual bonuses for traders -- which can make up more than 75 percent of total compensation -- are largely based on how much money each individual makes for the firm.

By the middle of 2006, the Merrill traders who bought mortgage securities were often clashing with the powerful division, run by Harin De Silva and Ken Margolis, which created and sold the CDOs. At least three traders began to refuse to buy CDO pieces created by De Silva and Margolis' division, according to several former Merrill employees. (De Silva and Margolis didn't respond to requests for comment.)

In late September, Merrill created a $1.5 billion CDO called Octans, named after a constellation in the southern sky. It had been built at the behest of a hedge fund, Magnetar, and filled will some of the riskier mortgage-backed securities and CDOs. (As we reported in April with Chicago Public Radio's This American Life and NPR's Planet Money, Magnetar had helped create more than $40 billion worth of CDOs with a variety of banks, and bet against many of those CDOs as part of a strategy to profit from the decline in the housing market.)

In an incident reported by the Wall Street Journal ($) in April 2008, a Merrill trader looked over the contents of Octans and refused to buy the super-senior, believing that he should not be buying what no one else wanted. The trader was sidelined and eventually fired. (The same Journal article also reported that the new group had taken the majority of Merrill's super-seniors.)

The difficulty in finding buyers should have been a warning signal: If the market won't buy a product, maybe the bank should stop making it.

Instead, a Merrill executive, Dale Lattanzio, called a meeting, attended by among others the heads of the CDO sales group -- Margolis and De Silva -- and a trader, Ranodeb Roy. According to a person who attended the meeting, they discussed creating a special group under Roy to accept super-senior slices. (Lattanzio didn't respond to requests for comment.)

The head of the new group, Roy, had arrived in the U.S. early in the year, having spent his whole career in Asia. He had little experience either with the American capital markets or mortgages. His new unit was staffed with three junior people drawn from various places in the bank. The three didn't have the stature within the firm to refuse a purchase, and, more troubling, had little expertise in evaluating CDOs, former Merrill employees say.

Roy had reservations about purchasing the super-senior pieces. In August 2006, he sent a memo to Lattanzio warning that Merrill's CDO business was flawed. He wrote that holding super-senior positions disregarded the "systemic risk" involved.

When younger traders complained to him, Roy agreed it was unwise to retain the position. But he also told these traders that it was good for one's career to try to get along with people at Merrill, according to a former employee.

But Roy and his team needed to be paid. As they were setting up the trading group, Roy raised the issue of compensation. "The CDO guys said this helps our business and said don't worry about it -- we will take care of it," recalls a person involved in the discussions.

The agreement, according to a former executive with direct knowledge of it, generally worked like this: Each time Merrill's CDO salesmen created a deal, they shared part of the fee they generated with the special group that had been created to "buy" some of the CDO. A billion-dollar CDO generated about $7 million in fees for Merrill's CDO sales group. The new group that bought the CDO would usually be credited with a profit between $2 million and $3 million -- despite the fact that the trade often lost money.

Sharing the bonus money for a deal or trade is common on Wall Street, arrangements known as "soft P&L," for "profit and loss." But it is not typical, or desirable, to pay a group to do something against their financial interests or those of the bank.

Roy made about $6 million for 2006, according to former Merrill executives. He was promoted out of the group in May 2007, but then fired in November of that year. He now is a high-level executive for Morgan Stanley in Asia. The co-heads of Merrill's CDO sales group, Ken Margolis and Harin De Silva, pulled down about $7 million each in 2006, according to those executives. De Silva is now at the investment firm PIMCO.

By early summer 2007, many former executives now realize, Merrill was a dead firm walking. As the mortgage securities market imploded, high-level executives embarked on an internal investigation to get to the bottom of what had happened. It did not take them long to discover the subsidy arrangement.

Executives made a sweep of the firm to see if there were other similar deals. We "made a lot of noise" about the Roy subsidy to root out any other similarly troublesome arrangements, said one of the executives involved in the internal investigation. "I'd never seen it before and have never seen it again," he says.

In early October 2007, Merrill began to purge executives and, slowly, to reveal its losses. The heads of Merrill's fixed income group, including Dale Lattanzio, were fired.

Days later, the bank announced it would write down $5.5 billion worth of CDO assets. Less than three weeks after that, Merrill raised the estimate to $8.4 billion. Days later, the board fired Merrill's CEO, Stan O'Neal.

Eventually, Merrill would write down about $26 billion worth of CDOs, including most of the assets that Ranodeb Roy and his team had taken from De Silva and Margolis.

After Merrill revised its estimate of losses in October 2007, the Securities and Exchange Commission began an investigation to discover if the firm's executives had committed securities fraud or misrepresented the state of its business to investors.

But then the financial crisis began in earnest. By March 2008, Bear Stearns had collapsed. By the fall of 2008, Merrill was sold to Bank of America. In a controversial move, Merrill paid bonuses out to its top executives despite its precarious state. The SEC turned its focus on Merrill and BofA's bonuses and sued, alleging failures to properly disclose the payments.

As for the original SEC probe into Merrill Lynch's CDO business in 2007, nothing ever came of it.

As I have written, when we peel back the layers of the real estate "onion" what we find is layer after layer of fraud. From the mortgage brokers to the appraisers and lenders, from the securitizers to the ratings agencies and accountants, from the trustees to the servicers, and from MERS (Mortgage Electronic Registry System) through to the foreclosures, what we find is a massive criminal conspiracy—probably the worst in human history. I realize that is a harsh claim but I cannot find any other words that fit.

In the old days, we used to hang horse thieves. The justification was that a man's horse was necessary to his way of life, and in some cases, to his very survival. There can be little doubt that a home is equally important to maintenance of a middle class living standard today for most Americans. There is almost no calamity worse than loss of one's home. It is the main asset that most Americans hold—essential to the educational success of one's children, and to a comfortable retirement of our citizens.

Americans typically borrow against their home equity to put their kids through college, to ease the financial distress caused by unexpected health care expenses, and to finance other large expenditures. The accumulated equity in the home is the only significant source of wealth for the vast majority of Americans. The home is necessary to one's continuing connection to the neighborhood, school district, and network of friends. Theft of one's house today is certainly equivalent to theft of a horse 150 years ago.

And, yet, we are not hanging the thieves who are stealing millions of homes from Americans. The thievery today is orders of magnitude greater than the horse thievery of the distant past. Today's foreclosure thieves have stolen more property of citizens than all previous thieves combined since the founding of our nation. The only thing that could trump it would be the theft of property and livelihood from our native Americans. To be sure, we have evolved as a nation, and I would not advocate hanging those responsible.

But without question they ought to be incarcerated in prison, with long terms and with confiscatory monetary penalties—perhaps 10 years for anyone who helps to improperly foreclose on a homeowner's property, and $10 million for each case of fraudulent foreclosure. That would provide the proper incentive as well as the proper monetary reward that will be required to get good lawyers to take cases of homeowners who are being illegally thrown out of their homes every minute of every day.

The real estate finance sector is trying to pin the blame on some sloppy paperwork and overburdened workers. They promise to put things right, hiring more workers to work diligently to dot those eyes and cross those tees. In reality it was all fraud, intentional and massive. Home theft was the business model. That is what the Bush administration meant when it pushed the "ownership society"—a society in which the top tenth of one percent would own everything.

First, they changed bankruptcy laws so that a first mortgage on one's principal residence is the only debt a judge cannot reduce. This was to ensure that when the wave of foreclosures began, those who lost their homes to the true ownership class would still have to pay off the mortgage. Next, they created "affordability" products—such as the neutron bomb hybrid adjustable rate mortgages hawked by Chairman Greenspan--that were designed to blow up the borrowers while leaving the real estate intact. Then they created derivatives—the so-called mortgage backed securities--sold to investors.

Toxic waste derivatives were then re-packaged into even more trashy collateralized debt obligations that were sold to bank customers, with banks buying credit default swap "insurance" to place bets against their own customers.

The banks then farmed out mortgage servicing to their own subsidiaries, "misplacing" payments that ought to have gone to the securities holders. This was in order to claim borrowers were delinquent so that the servicers could squeeze late fees and default fees and extra interest out of them. Investors in the securities would be last in line, with the servicers maximizing their own incomes and protecting the interests of their mother banks (which often had second liens on the properties in the form of home equity loans).

This is why the servicers make it so difficult to modify the loans—which is in the interests of the borrowers and the investors, but against the interest of the banks with second liens. And they created MERS to operate as a foreclosure steam roller, which outsourced the foreclosures back to the servicers with deputized "vice presidents" pretending to be officers of MERS in order to scam the courts.

We now know that the "mortgage backed" securities were not backed by mortgages. In reality they are unsecured debt. The "pooling and servicing agreements" (PSAs) that govern securitization require that the mortgage documents (including the wet ink notes as well as a clean chain of title) are transferred in a timely manner to the trustees.

This was rarely and perhaps never done, because it was counter to the recommendation made by MERS (Mortgage Electronic Registry System). Instead, notes were either destroyed or held by the servicers to speed the foreclosures that were always envisioned as the end result of the mortgage origination process. Not only does this practice render the securities fraudulent but it also violates the federal tax laws that govern the REMICs—meaning back taxes are due.

But worse than all that, by breaking the chain of title and by destruction of documents, MERS and the servicers have jeopardized the entire system of property rights. Most, perhaps all, foreclosures have been fraudulent, which means that resales of the homes are also frauds. It goes without saying that the original mortgages were frauds from the very beginning—to complete the transformation to the ownership society it was necessary to ensure that by construction, default was inevitable.

Either the homeowner would be unable to pay, or the servicer would "lose" the payments. By obscuring the chain of title, it would be impossible for the debtors or the courts to sort things out. Separating home owners from their property was necessary to ensure that we can create Bush's ownership society. It is the modern form of the feudal foreclosures and seizures of peasant lands that concentrated ownership in the hands of agricultural capitalists—creating the first ownership society.

The scale of the problem is huge. Some estimate that as many as $6.4 trillion worth of home mortgages (33 million of them) are frauds, with destroyed or doctored documents. Probably all of the $1.4 trillion worth of private label residential mortgage "backed" securities violate the PSAs—so are actually unsecured debt. Three state supreme courts have already ruled that MERS cannot be the owner of mortgages, hence, has no standing in foreclosures.

MERS contaminated 65 million mortgages—decoupling the mortgages from the notes and destroying the chain of title. A consortium of investors (including PIMCO, Black Rock, and Fannie and Freddie) that owns $600 billion of the private label securities are suing the banks to take them back. One investor action alone against Bank of America concerns $47 billion in fraudulent mortgages—enough to put a serious dent in its purported net worth of $230 billion (which is probably a vast overstatement resulting from cooking the books).

A suit in California seeks $60-$120 billion in lost recording fees alone. All 50 states are investigating the servicers for fraud. The top five servicers (Bank of America, Wells Fargo, JPMorgan Chase, Citigroup, GMAC-Ally) have 60% of the business and include the top four banks that account for 40% of the banking business.

It is time to push the reset button. All foreclosures should be stopped immediately. The REMIC trustees should be audited to see if they have properly followed the requirements of the PSAs and laws applying to REMICs. If they do not have the notes, the securities should be put back to the banks. If the banks cannot absorb the losses, they must be closed and resolved.

The FDIC in turn will end up with the mortgage backed securities and underlying mortgages. Working with Freddie and Fannie, all of these should be modified, into new fixed rate mortgages—with a "clawback" to reset principle to current market value of the homes, and with new notes. Investors are going to take losses so there will be fall-out that government will have to address. There will be hundreds of billions of dollars of losses. Congress must find a way to mitigate effects on the economy as well as on investors in MBSs and other assets related to real estate. This is a big problem, but it is not insurmountable.

Every top management official of all the biggest dozen banks, plus everyone at MERS, all officers of every servicer, rater, appraiser, accounting firm, and mortgage broker ought to be investigated for fraud. In the aftermath of the thrift crisis, 1852 bank insiders were prosecuted and 1072 were jailed. So far in this much bigger crisis there have been only 50 criminal probes and 80 civil lawsuits authorized by FDIC. It is time to get serious about the home thieves.

Allstate Corp has sued Bank of America Corp, its Countrywide lending unit and 17 other defendants for allegedly misrepresenting the risks on more than $700 million of mortgage securities it bought from Countrywide. Allstate, the largest publicly traded U.S. home and auto insurer, alleged it suffered "significant losses" after Countrywide misled it into believing the securities were safe, and the quality of home loans backing them was high.

The lawsuit also names several former Countrywide officials as defendants, including longtime Chief Executive Angelo Mozilo. Countrywide was the largest U.S. mortgage lender before Bank of America bought it in July 2008. Allstate said that starting in 2003, Countrywide quietly decided to boost market share and ignore its own underwriting standards by approving any mortgage product that a competitor was willing to offer, in a "proverbial race to the bottom."

Countrywide then passed on the added risks to investors who bought debt backed by the mortgages, Allstate said. "Defendants knew the loans offloaded onto Allstate were a toxic mix of loans given to borrowers that could not afford the properties, and thus were highly likely to default," said the 150-page complaint filed on Monday in Manhattan federal court. Allstate seeks to undo its securities purchases, which took place between 2005 and 2007, plus unspecified damages. The Northbrook, Illinois-based company joined Charles Schwab Corp, the Federal Home Loan Banks and others in suing lenders for allegedly misleading them about mortgage securities.

Bank of America, the largest U.S. bank by assets, last month said it faced lawsuits over $54 billion of such debt. A spokesman, Bill Halldin, in an email said the Charlotte, North Carolina-based bank is reviewing the complaint. "This unfortunately appears to be a situation where a sophisticated investor is looking for someone to blame for a downturn in the economy and losses on an investment it made," he said.

David Siegel, a partner at Irell & Manella LLP who represents Mozilo, said in an email that Allstate has "retread allegations with no merit; and certainly no basis to name Mr. Mozilo other than to try to capture publicity." Daniel Brockett, a partner at Quinn Emanuel Urquhart & Sullivan LLP who represents Allstate, did not return a call seeking comment.

ProbesMozilo agreed in October to a $67.5 million settlement of a U.S. Securities and Exchange Commission civil fraud lawsuit. The SEC accused Mozilo of misleading investors about Countrywide's health and risk-taking, and generating roughly $140 million of improper gains from insider stock sales. Mozilo was the first top executive personally punished over alleged wrongdoing tied to the nation's housing collapse. Bank of America agreed to cover two-thirds of his penalty. Mozilo did not admit wrongdoing in agreeing to the SEC accord.

Bank of America also is among banks including Citigroup Inc, Goldman Sachs Group Inc, JPMorgan Chase & Co and Wells Fargo & Co to face SEC subpoenas as the regulator examines how mortgages were packaged for sale to investors, people familiar with the probe said. The U.S. Justice Department and all 50 U.S. state attorneys general also are probing wrongdoing in mortgages, while Arizona and Nevada accused Bank of America in a lawsuit of misleading borrowers about home loan modifications.

The world’s largest clearinghouse for credit-default swaps, ICE Trust, has had second thoughts about registering with regulators, citing concerns over new rules devised to bring transparency to the $600 trillion derivatives market. ICE Trust, a division of the Intercontinental Exchange, the big derivatives exchange, applied to be a derivatives clearing organization with the Commodity Futures Trading Commission in November. Last week, the company quietly withdrew its application.

In a Thursday letter to the commission, which was released on Tuesday, a lawyer for ICE Trust said the company changed its mind because of "significant changes proposed to" regulations for clearing organizations. The gesture may be symbolic. In July, ICE Trust will automatically be granted status as a clearinghouse, under the Dodd-Frank financial overhaul law. A spokesman for ICE declined to comment.

ICE, which has cleared more than $14 trillion of credit-default swaps since it started in 2009, said it had applied with the commission to bring its operations into compliance more quickly and to attract new customers before the rules went into effect in July. But the clearinghouse decided to hold off, owing to uncertainty around the process. Over the last several weeks, the agency has outlined several proposals for clearinghouses, including a plan to limit conflicts of interest and to open the market to more competition. ICE, the dominant player in derivatives clearing, has been criticized in the past for pushing aside smaller players.

Under the Dodd-Frank rules, the trading commission and the Securities and Exchange Commission have broad authority to regulate swaps — complex financial instruments, some of which collapsed during the financial crisis. The law requires big banks and other financial institutions to process the opaque investments through regulated clearinghouses, which serve as a backstop in case one party defaults. The rules also require swaps to be traded on regulated exchanges or on so-called swap execution facilities.

Sweden’s central bank may set the direction for other policy makers as it looks beyond conventional inflation targets to asset-price growth in an effort to prevent the next bubble.

"Not countering asset-price increases has been the conventional wisdom among central banks, but what has it actually resulted in?" said Tina Mortensen, an economist at Citigroup Inc. in London. "Surely the current crisis has made central bankers rethink policy; Sweden is actually facing this problem" because "asset prices and monetary policy are a hot topic," she said.

Riksbank Governor Stefan Ingves has raised the repo rate four times since July even as inflation remains below the bank’s 2 percent target. The increases occurred as house prices move above pre-crisis levels and credit growth hovers near 9 percent. While Sweden raises rates, the U.S., the euro region, Japan and the U.K. are keeping borrowing costs at record lows.

The financial crisis that started more than two years ago was exacerbated by central banks holding rates too low as inflation gauges failed to capture asset-price growth, according to Johnny Akerholm, president of the Helsinki-based Nordic Investment Bank. He says most policy makers are repeating the mistake.

"We are practically re-running the same situation these days," he said in his bank’s Dec. 17 newsletter. "Rates are low and the central banks are 'printing money’ while virtually all prices, except the consumer prices in industrial countries, are increasing rapidly."

Rates 'Normalized’Policy makers in Europe and the U.S. have started to warn of the risks associated with low rates. Bank of England Monetary Policy Committee member Andrew Sentance voted for a seventh month to raise the benchmark from a record-low 0.5 percent at the bank’s Dec. 9 meeting. Paul Fisher, the bank’s markets director, told the Daily Telegraph last week that rates should be "normalized" to about 5 percent.

European Central Bank Executive Board member Juergen Stark says monetary policy should address the threat of financial imbalances and wants forecasting models to provide broader gauges of the economy. He’s spent the past year warning that an extension of the ECB’s liquidity program risks sowing "the seeds for new imbalances."

Still, ECB President Jean-Claude Trichet said as recently as Dec. 2 the bank will keep providing emergency funds to banks through the first quarter. The ECB’s benchmark rate has remained at a record low 1 percent since May 2009.

Mopping Up BubblesIn the U.S., Kansas City Fed President Thomas Hoenig said this month the "continued high level of monetary accommodation" may "destabilize the economy." The Fed has kept its main rate at zero to 0.25 percent since December 2008. The Fed said last month it will buy $600 billion of Treasuries through June, helping keep yields low.

"There’s a risk that if policy makers react to a bubble bursting by aggressively loosening monetary policy, it may lead to new damaging bubbles emerging," said Ben May, an economist at Capital Economics Ltd. in London. "The conventional wisdom amongst policy makers has been that you shouldn’t lean on bubbles and that the best thing to do is just to try to mop them up when they burst. In hindsight, that looks like a mistake."

Swedish headline inflation has lagged behind the Riksbank’s target since December 2008. Inflation adjusted for mortgage costs will remain below target through 2013, the bank estimates.

Growth vs DebtHouse prices, by contrast, rose for a 19th consecutive month in the quarter through November, gaining at an annual rate of 5 percent. The Riksbank, which raised its repo rate to 1.25 percent on Dec. 15, said then higher rates are needed to slow credit growth. The bank is also trying to steer the fastest economic rebound in the European Union as it estimates growth of 5.5 percent this year. It expects the repo rate to average 3.3 percent in 2013, while economic growth will slow to 2.3 percent in 2012.

"The focus on issues such as the level of household debt suggests the Riksbank might rather have a period of slightly weaker growth or below-target inflation than a surge in indebtedness and perhaps another boom in house prices," May said. Fed Chairman Ben S. Bernanke said in a Nov. 16 speech that policy makers "have to keep an open mind" on the possibility of using interest rates to pop asset bubbles. He added that the "best approach here, if at all possible, is to use supervisory and regulatory methods."

Bypassing RulesOutside Europe and the U.S., Bank of Israel Governor Stanley Fischer has incorporated bubble fighting into policy in a country where housing supply is shaped by government control of land. Fischer, who also oversees Israel’s banking regulation, left the benchmark rate at 2 percent this week in part because house prices cooled.

According to Mortensen at Citigroup, regulation alone has done little to cool Sweden’s house-price growth. Banks, which have had to cap mortgage lending at 85 percent of a property’s value since Oct. 1, "just seem to come up with alternative products" to bypass the rule, Mortensen said. "I wouldn’t be surprised, given what we have just been through, if this leads to some kind of rethinking, also globally," she said.

"The strongly increased risks of central banks may act as a constraint on the room for manoeuvre in future monetary policy." That is the worst case scenario laid out by new research from the Bank of Finland.

The thoughtful, comprehensive analysis of eight central banks looks at unconventional tools adopted during the crisis, concluding: "The actions by central banks during the crisis raise a number of questions concerning exit from the measures taken, the impact of the measures, central banks’ risks and independence and their governance structures."

The turn of the year – and the final post on this blog for 2010 – make a summary of this paper seem appropriate. Which of the unconventional tools – if any – will be discarded in 2011?

Despite wide differences in situation going into the crisis, "central bank actions bear witness to … convergence rather than divergence," argues the paper. The maturities of open market operations, for example, were extended by all central banks in the study (the RBA, ECB, SNB, Riksbank, BoJ, BoE, Fed and Bank of Canada) – many up to 12 months.

All central banks expanded the list of assets accepted as collateral. Many broadened their range of counterparties. Swap lines were opened to aid liquidity. All central banks other than Canada and Sweden have started purchasing securities outright, vastly expanding their balance sheets.

"As a result of the operations carried out, central bank balance sheets have grown very strongly in all the countries other than Japan," says the paper. This from outright asset purchases as well as fixed-rate full allotment tender processes in open market operations (i.e. where the amount bought by the central bank is entirely demand led).

Central bank balance sheets as a proportion of GDP have roughly doubled in the examples given, with Switzerland leading the way at 40 per cent. Other kinds of risk have been taken on by some central banks – such as FX risks as Switzerland tried to dampen its appreciating franc, or equity risks as Japan tried to support its stock market.

The basic conclusion is that central bank risks have vastly increased in the past two years. But these aren’t just financial risks. Banks’ motivations and objectives have expanded along with their balance sheets – particularly into areas previously considered the remit of the markets. Central banks now adopt explicit market-orientated goals, such as influencing long-term yields, improving liquidity, calming the markets and reducing risk premia.

New behaviours can, in theory, be rolled back when conditions permit. But new objectives and goals are harder to shed, once people are hired, expectations altered and identities changed. We are still in crisis mode, to some extent, but perhaps it is not too soon to start a critical analysis of which temporary measures are usefully made permanent.